report of irdai working group - icmai.in
TRANSCRIPT
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Report of IRDAI
Working Group On
Revisiting Guidelines on
Trade Credit Insurance
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Smt. T. L. Alamelu
Member (Non-Life)
Insurance Regulatory Development Authority of India
Hyderabad
Respected Madam,
Re: Report of the Working Group on revisiting Guidelines on Trade Credit Insurance
I have pleasure in submitting the Report of the Working Group on the above subject
created vide IRDAI order IRDAI/NL/ORD/MISC/133/08/2019 dated 29th August, 2019.
The Report and the Recommendations contained are an outcome of extensive review of
existing guidelines vis-à-vis the needs of the stake holders and changing trends of
business through meetings with stake holders and intense deliberations by the Working
Group. This report covers the following aspects.
1. Understanding Credit Insurance
2. Analysis of Credit Insurance Market in India and Worldwide
3. Credit Insurance for Banks and Factoring Business
4. Micro, Small and Medium enterprises
5. Online Trading Electronic Platforms such as TReDS
On behalf of the Members of the Working Group, I sincerely thank you for entrusting us
with this responsibility. I also thank you for granting extension of time to the Working
group to come up with a comprehensive report on the subject.
Place: Hyderabad Atul Sahai
Date: 11.05.2020 Chairman of the Working Group
Members
Mr. Subrata Mondal
Mr. Mukund Daga
Mr. Parag Gupta
Mr. Rajay Sinha
Mr. Umang Rathod
Mr. S.P. Chakraborty
Mrs. Latha. C
Mr. Jyothi Prasad Adike
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CONTENTS
1. Acknowledgements - ……………………............................................. 4
2. Executive Summary - ……………………. ............................................ 5
Chapters
1. Concept of Credit Insurance ..........................................................9
2. Credit Insurance Landscape – Global & India............................... 29
3. Factoring .................................................................................... 44
4. Micro, Small & Medium Enterprises ........................................... 57
5. Recommendations on existing guidelines ................................... 70
6. Additional Recommendations ...................................................... 92
7. Sources ........................................................................................ 94
8. Abbreviations .............................................................................. 95
Annexures
1. IRDAI Order ................................................................................. 97
2. Extracts from RBI master circular on Prudential
Guidelines on Capital Adequacy and Market Discipline
New Capital Adequacy Framework (NCAF) - July 1, 2015 .............. 99
3. Extracts from RBI Master Circular Basel III Capital
Regulations – July 1, 2015 .......................................................... 102
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Acknowledgements
At the outset, the working group thanks Chairman, IRDAI and Member (Non-Life),
for taking initiative to revisit the guidelines on Trade Credit Insurance, at the time
of need, and providing an opportunity to review the existing guidelines and
suggest recommendations which may improve the opportunities of the insurers in
providing valuable credit insurance services to the needy sectors.
The Working Group acknowledges with gratitude the co-operation and assistance
of Smt. Yegnapriya Bharath, Chief General Manager and Shri K. Mahipal Reddy,
General Manager, IRDAI in reviewing the progress of the Working Group and
pushing forward the regulatory perspective.
The Working Group places on record its sincere appreciation and thanks to
various stakeholders including ICICI Bank, Coface, Atradius, India Factoring and
other trade bodies for providing valuable contributions through their
representatives and through other means of correspondence.
The Working Group extends gratitude to ECGC Limited for showing interest and
nominating Mr. Subir Kumar Das, General Manager, as a permanent invitee to the
Working Group meetings, whose contribution in the areas of export credit
insurance to banks and exporters is highly appreciated.
The Working Group wishes to thank Mrs. Saraswathi Chidambaram, Manager, The
New India Assurance Co. Ltd., for sharing her expertise and providing valuable
inputs during the meetings.
The Working Group would like to specially thank IRDAI and The New India
Assurance Co. Ltd., for providing the necessary space and infrastructure in
facilitating the discussions.
Last but not the least the Working Group is extremely grateful to the
managements of the companies/organizations that the Working Group members
represent for having provided the members with time and resources for
completing this report.
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Executive Summary
Trade Credit Insurance (TCI) is an effective risk management tool for the suppliers
of goods and services and other financial institutions, to mitigate non-payment
risks and insolvency/default of the buyers for both domestic and global scenarios.
TCI thus enables suppliers in exploring new markets and expanding their
businesses, which in turn results in significant increase in their sales turnover and
profitability of their business. Simultaneously, TCI helps in supporting Banks,
factoring companies and other financial institutions, which provide finance to
suppliers by way of discounting/purchase of bills.
TCI contributes to the economic growth of a country by facilitating trade and
helps in improving economic stability by addressing the trade losses due to
payment risks. However, the regulatory framework must facilitate insurance
companies to offer better credit insurance covers to suppliers as well as banks
and other financial institutions. TCI is one of the driving factors in flourishing
trade and financial markets in developed economies.
In the Indian context, the present guidelines on TCI, issued in 2016, do not allow
the insurance companies to offer full fledge benefits that provides much needed
protection to suppliers and restricts TCI covers to banks and financial institutions.
Credit Insurance market in India is dominated by ECGC Limited, a Govt. of India
enterprise which provides only export credit insurance facilities to banks and
exporters. Domestic credit insurance on the other hand is also being provided by
all insurance companies except ECGC.
Around 82% of the total Credit Insurance business is contributed by ECGC Limited,
which is outside the purview of the Trade Credit Insurance guidelines. The
balance around 18% is contributed by other general insurance companies, both
public and private, governed by the Trade Credit Insurance guidelines. Credit
insurance business in India, other than ECGC, has shown a growth rate of around
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18% over the last two years. However, the insurance premiums amount to Rs.
277.68 cr during 2018 -19 for insurance companies other than ECGC, which is
quite miniscule vis-a-vis the size of Indian Economy.
With the Govt. of India’s initiative to improve businesses for the MSMEs, which
are considered as the backbone of the national economic structure, it is also
imperative to relax the trade credit insurance guidelines to support the business
environment. The insurance companies have to be enabled to offer TCI services
with enhanced covers at affordable premiums to boost the MSME sectors. At the
same time, it is equally important to make availability of TCI facilities to Banks, FIs,
factoring companies, etc who also provide finances & liquidity to them.
The report analyses the need to revisit the present guidelines in the context of
providing necessary impetus to the economy by addressing TCI requirements of
various business segments. The report provides a deep study of TCI and helps to
understand the TCI business in various segments. Credit insurance markets across
the globe are reviewed and regulatory framework in some of the countries have
been examined. The report also provides a comprehensive study of factoring
business, bank finance and business contributed by Micro, Small and Medium
enterprises in India along with relevant regulatory framework.
Following are the key recommendations classified into 3 parts which have been
advised by the working group study.
Changes in Current Guidelines:
Certain Key Definitions in the guidelines have been modified to add better
clarity & understanding.
The indemnity provided to the policy holders should be allowed to
increase from 85% to 90% for all policy holders & 95% in case of political
risk for Micro & Small Enterprises.
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Every Insurer shall have Board Approved Risk Management Guidelines
which should be filed with the Authority while taking approvals for this
product category.
The aggregate net retentions of the insurer for Trade Credit Insurance
shall be as per the applicable reinsurance regulations & amendments
thereof.
Additions proposed to the Guidelines:
The committee had various discussions and deliberations with various stake
holders like Banks / Financial Institutions, Factoring Companies, Export Councils
and Trade Bodies to understand their expectations from Trade Credit Insurance as
risk mitigation tool. Keeping in mind the evolving needs of MSMEs and Banks, the
committee has also suggested to add the following new options under trade
credit insurance:
Banks, Factoring Companies, FIs & similar entities shall be allowed to avail
Credit Insurance to cover trade related transactions which was not
permitted earlier.
Banks, Factoring Companies, FIs & similar entities should not be permitted
to cover loan default of Seller.
No Credit Policy shall cover Reverse Factoring Transactions.
Single buyer risk covers should be allowed only for Micro & Small
enterprises.
Single Invoices cover shall be availed on Invoice Discounting e-platforms
such as TReDS or any similar types of platform.
The insurance companies will now be able to offer wider range of credit insurance
products with enhanced covers at affordable premiums to boost the SME and
MSME sectors.
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Working Group Recommendations:
Creation of a Buyer Default Database with IIB to keep a check on the
defaulters & better risk mitigation process
RBI to recognize Credit Insurance Products as risk mitigation tools for
Banks to make it eligible for Capital Relief.
The work group has made the recommendations keeping in mind the TCI needs of
the suppliers of goods and services, esp. Micro & Small enterprises in India and
how these changes can help them with simplified and necessary risk mitigation
tools. By allowing Banks, FIs and new age Invoice Discounting Digital platforms to
cover trade risks, this much deprived segment will also be benefitted in getting
additional liquidity from their receivables.
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CHAPTER 1
Concept of Credit Insurance
1.1
Trade credit insurance (also known as credit insurance, business credit insurance
or export credit insurance) is an insurance policy and risk management tool that
covers the non-payment risk of buyers resulting from the delivery of goods or
services. Trade credit insurance usually covers a portfolio of buyers and
indemnifies an agreed percentage of an invoice/s that remains unpaid as a result
of protracted default, insolvency / bankruptcy.
Depending upon the nature of business this insurance may also be offered for
Single Buyer insurance
Top buyer insurance
Single shipment insurance
However, in such insurances, the premium is charged on exposures of buyers,
rather on turnover.
It is purchased by business entities to insure their receivable from loss due to the
non-payment of valid debt by their debtors. It can also be expanded to cover
losses resulting from political risks such as currency inconvertibility; war and civil
disturbance; confiscation, expropriation and nationalization.
The costs (called a “premium”) for this are usually charged as a percentage of
sales or as a percentage of all outstanding receivables, depending on the policy
structure.
Trade Credit insurance covers have historically developed as a Business to
business cover and cannot cover individuals’ risk.
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1.2
Globally Trade credit insurance is bought for three reasons:
Why Trade Credit Insurance is Purchased
Risk Mitigation/Transfer
Increasing the reach
Manage Cash flow
Risk Mitigation:
Trade credit insurance by virtue of its structure provides relief as the last resort
for a seller. Wherein despite of best effort to choose the genuine buyers, provide
best of products and services as per requirement and delivering as per the
schedule expected from seller, the buyer fails to pay on the due date.
The policy is designed in a fashion, wherein once the buyer crosses the due date
of payment, the seller is expected to inform the insurer after a pre-decided period
about the non-payment. The seller however is expected to continue chasing the
buyer for payment.
The insurer assesses the buyer-seller transaction for unpaid dues and assist seller
to recover the over dues amicably. However, if the amicable recovery fails within
a specified time, the insurer pays the seller by way of indemnity and take
subrogation of right to recovery from buyer.
This way, the program assists in risk mitigation
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Increasing the reach:
Trade credit insurers typically have large teams of risk underwriters who manage
huge database for buyers across the world. Wherein these teams collate buyers’
financial data, transaction data, bank details, historical business relationship with
various sellers etc.
On other side for a seller, it is a herculean task for them whenever they want to
diversify either by reaching new geographies, new product lines, new sectors. As
the seller is new to this opportunity, they have opaque or minimum visibility of
buyer’s financial or intent.
Trade credit insurer here help the seller by way of providing them insight on right
exposure on each buyer to start the business, monitoring the buyers for any
adverse information during business and assisting the sellers with debt recovery
in case of default.
This helps sellers diversify safely not only to conduct existing business safely but
also expand business with confidence
Manage Cash flow:
Cash flow is the core of any business and globally trade credit insurance have
single handedly supported businesses across the world. In today’s world, because
of information technology and improvement in logistics, whole sellers are
reaching buyers across the world, price and product differentia have diminished.
The only differential which a seller, especially small and medium size company
could be there financial strength to provide extensive credit terms. Aggressive
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credit terms are double edged sword wherein on one side it helps businesses to
grow, but it also restricts turnover.
This is where trade credit insurance supports sellers. The seller can either buy the
trade credit insurance and assign the policy to a bank and sell their receivables,
thus getting immediate relief by infusion of cash in business OR
Banks buys insurance by way of factoring policies, insurance backed channel
finance program, Insurance backed dealer finance program and other insurance
backed trade solution to provide support to seller manage cash flow.
This cash flow thus helps sellers to reinvest in the business by realizing the
receivables upfront.
1.3
Fundamentals of Trade Credit Insurance
Policy holders require a credit limit on each of their buyers for the sales to that
buyer to be insured. The premium rate reflects the average credit risk of the
insured portfolio of buyers. Additional premium is payable if the cover is
expanded to include political risks. In addition, credit insurance can also cover
single transactions with longer payment terms or trade with only one buyer,
normally large transactions.
Trade credit risk insurance is an insurance policy and a risk management product
offered by private insurance companies and governmental export credit agencies
to business entities wishing to protect their accounts receivable from loss due to
credit risks, such as protracted default, insolvency, bankruptcy, etc. Trade credit
insurance can also include a component of political risk insurance, which is
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offered by the same insurers to insure the risk of non-payment by foreign buyers
due to the actions or inactions of the buyer’s government. This leads to the major
role that trade credit insurance plays in facilitating domestic and international
trade.
Trade credit is offered by suppliers to their customers as an alternative to pre-
payment or cash on delivery terms, or the need for expensive bank letters of
credit, providing time for the customer to generate income from sales before
paying for the product or service. This requires the supplier to assume non-
payment risk. In a local or domestic situation, as well as in a cross border or
export transaction, the risk increases when laws, customs, communications and
customer’s reputation are not fully understood by the supplier.
Trade credit insurance thus enables suppliers to significantly increase their overall
sales turnover, reduce credit risk related losses and improve the profitability of
their business. At the macroeconomic level, trade credit insurance helps to
facilitate international trade flows and contributes to the global economic growth,
allowing transactions to occur that would otherwise have been too risky. It also
enhances economic stability by sharing the risks of trade losses with the trade
credit insurers, who are better equipped to absorb them.
In the absence of trade credit insurance, the suppliers would have no choice but
to rely on either full pre-payment for goods and services by buyers or to seek a
third party which is willing to take the credit risk for a price. Hence, traditionally,
trade credit insurers must compete with banking and capital market products.
The most common banking product has been the letter of credit, an established
substitute for trade credit insurance, and most used in the export sector. Trade
credit insurers also compete with factoring, whereby a bank or other financial
firm buys a company’s receivables for an immediate, but discounted payment.
However, factoring companies often buy credit insurance to cover the risk of not
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collecting on their trade receivables, and so the two products complement one
another. Until the recent credit crisis, large suppliers could also sell their
receivables at a discount to capital market investors in the form of asset-backed
commercial paper.
The essential value of trade credit insurance is that it provides not only peace of
mind to the supplier, who can be assured that their trade is protected, but also
valuable market intelligence on the financial viability of the supplier’s customers,
and, in the case of buyers in foreign countries, on any trading risks peculiar to
those countries. As well as providing an insurance policy that matches the client’s
patterns of business, trade credit insurers will establish the level of cover that can
reasonably be provided to the supplier for trade with each individual buyer, by
analyzing the buyer’s financial status, profitability, liquidity, size, sector, payment
behavior and location.
The first trade credit insurance policies were offered by the British Commercial
Insurance Company established in 1820 to offer fire and life coverage. However,
trade credit insurance, as we now know it, was born at the end of nineteenth
century, but it was mostly developed in Western Europe between the First and
Second World Wars. Several companies were founded in every European country;
some of them also managed the political risks associated with exports on behalf
of their state. Since then, trade credit insurance has grown into a multi-billion
dollar line of business.
While trade credit insurance is often mostly known for protecting foreign or
export accounts receivable, there has always been a large segment of the market
that uses trade credit insurance for domestic accounts receivable protection.
Domestic trade credit insurance provides companies with the protection they
need as their customer base consolidates, creating larger receivables to fewer
customers. This further creates a larger exposure and greater risk if a customer
does not pay their accounts. The addition of new insurers in this area has
increased the availability of domestic cover for companies.
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1.4
What is Trade Credit Insurance? For example, a SME garment manufacturer sells
garments on credit to domestic and international clients. Because of previous bad
experience with buyers not paying, and the need to borrow against its
international receivables in order to grow its business, it seeks protection against
payment delays and non-payment by its buyers. A “whole turnover” trade credit
insurance policy, which covers all of the garment manufacturer’s buyers, the
“good, the bad and the ugly”, is the solution. In exchange for a premium, which is
based on the annual turnover and credit risk of its buyers, the garment
manufacturer receives protection up to an agreed percentage of any losses
incurred against late payment or the failure to pay by its buyers. It can then use
this trade credit insurance policy to borrow from its commercial bank against the
insured receivables, probably on better terms and conditions where the trade
credit insurer is a higher rated credit risk than the garment manufacturer.
Trade credit insurance protects a supplier from the risk of buyer non-payment,
which can occur due to commercial or (in the case of international trade) political
risks. The commercial risks normally covered are the insolvency of the buyer and
extended late payment, which is the failure to pay within a set number of days of
the due date (normally 60–180 days) and is known as protracted default. Political
risk involves non-payment under an export contract or project due to the actions
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or inactions of a buyer’s government. These risks may include currency
inconvertibility; transfer of payment; war and civil disturbance; confiscation,
expropriation and nationalization, etc.
Trade credit insurers normally only provide cover against political risks in
combination with coverage against commercial risk. Trade credit insurers
generally cover short-term commercial and political risks for periods not
exceeding 365 days, and normally for periods of between 90 and 180 days.
Medium term cover for periods up to 5-years are a small part of the business and
are generally provided by the relevant state-owned export credit agencies & now
by private insurers as well.
Trade credit insurers, as with most indemnity insurance products, maintain the
right to recover any losses from the buyer. This is known as the right of
subrogation and allows the insurer to “stand in the shoes” of the insured supplier
and take legal action against the delinquent buyers, which helps the insurer
manage and contain its overall loss position.
Trade credit insurers normally establish credit limits and terms of business (e.g.
maximum invoicing period and maximum payment period) on all supplier’s
buyers, using their extensive credit and trading information data base. In addition,
a trade credit insurer may grant automatic cover on buyer risks up to a
discretionary limit, which may be a percentage of the overall policy limit or the
credit limit on a buyer or based on the policy holder’s satisfactory payment
experience on the buyer on similar payment terms during previous one or two
years. These discretionary limits allow the supplier flexibility to transact business
with a new buyer or temporarily increase the level of business transacted with an
existing buyer, during peak business periods. However, in order to exceed these
discretionary limits, the supplier would be obliged to apply for a new or increased
credit limit from the insurer. The trade credit insurer also retains the right to
reduce or cancel credit limits of a specific buyer if it is financial situation, or the
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overall political situation in the case of exports, deteriorates. These changes will
only apply to future business and previously accepted risks remain covered.
Short-term trade credit insurance policies are normally “whole turnover”,
covering all company’s trade receivables, either globally or on a country by
country basis. While the insurer may exclude or limit cover for specific buyers it
may consider high risk or not credit worthy, the supplier (insured) may not select
which risks to cover, thus protecting the insurer against adverse selection
whereby the insured would seek to only cover its highest risks. The premium
charged by the trade credit insurer will reflect the overall credit worthiness of all
the covered buyers, which makes trade credit insurance a very cost-effective
method of risk management.
Most trade credit insurance policies are renewed on an annual basis, with the
premiums being calculated on the insured supplier’s annual turnover and its
historic loss ratio. Premium chargeable can based on underlying perceived risk
associated with different payment terms and risk groupings of countries in case of
exports. For new policies the premium rate is calculated at the start of the policy,
and a minimum premium charged based upon the forecast turnover for the
period of the policy, with the insured declaring its actual turnover on a monthly,
quarterly or annual basis. Where the actual annual turnover exceeds the
previously forecast turnover, then an additional adjustment premium is charged
calculated using the agreed premium rate established as a percentage of insured
turnover.
Trade credit insurance policies never cover 100% of the risks assumed, and
normally do not exceed 85% to 90% of the losses, thus ensuring that the insured
supplier is motivated to manage its buyers prudently, as the supplier will always
share in any losses. In addition, limits may be set whereby a loss has to exceed an
agreed threshold before a claim can be submitted to the insurer, or a deductible
can be established whereby the insured supplier will assume this first level of loss
for its own account.
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There is also a pre-established waiting period for protracted default of between
120 and 180 days, where the supplier must make every effort to recover the
outstanding payments from the buyer before the insurer will pay the loss. In the
event of insolvency, it is normally required that the receiver or liquidator
acknowledges the debt as being due and unpaid.
Although most trade credit insurance is written under whole turnover policies,
trade credit insurers also offer a range of products to meet the specific needs of
suppliers, for example:
• Specific account policies, covering only certain named accounts.
• Single account policies, covering only a single named buyer; and
• Catastrophic policies, which have a high deductible and there-fore only protect
the insured supplier against a catastrophic trade credit default in excess of the
amount of the deductible.
The scope of coverage will normally exclude inter-company (within same group or
associates) sales; sales to governments or entitles owned or controlled by
governments; goods sold benefiting from letters of credit; and cash sales.
In addition, many trade credit insurers, also offer other products consisting of
credit information and receivables collection management.
1.5
The need for trade credit insurance arises from the common practice of selling on
credit and the demand by buyers to trade on open account, where they only pay
for the goods and services after having on-sold them and are not willing to
provide any form of security, for example by way of full or partial advance
payment, bank guarantee or letter of credit. It should be remembered that trade
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receivables can represent 30% to 40% of a supplier’s balance sheet and
companies therefore face a substantial risk of suffering financial difficulties due to
the impact of late or non-payment.
Trade credit insurance, an important risk management tool for managing the risks
of late payment or a complete failure to pay, offers insured suppliers several
important benefits:
• It transfers the payment risk to the trade credit insurers, whose credit expertise,
diversification of risk and financial strength enable them to assume these risks;
• It provides insured suppliers with access to professional credit risk expertise and
related advice;
• It can help prevent insured suppliers from suffering liquidity shortages or
insolvency due to delayed or non-payments;
• It reduces earnings volatility of insured suppliers by protecting a significant
portion of their assets against risk of loss;
• It facilitates the access by insured suppliers to receivables financing and
improved credit terms from lending institutions, some of which will insist on
trade credit insurance before providing financing;
• It enables insured suppliers to extend credit to customers rather than requiring
payment in advance or on delivery, or requiring security such as a letter of
credit, thus allowing the supplier to effectively compete in a global marketplace
where many buyers only buy on credit; and
• Allows insured suppliers to move up the value chain and accept direct buyer
risk, thus cutting out the wholesaler or auction house.
While indemnification for losses is what most suppliers recognize as the main
reason to purchase trade credit insurance, the most common reason to invest in a
trade credit insurance policy is because it helps the supplier increase their sales
and profits.
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Trade credit insurance can also improve a supplier’s relationship with their lender.
In some cases, a bank will require the supplier to buy trade credit insurance to
qualify for accounts receivable financing.
Please note that Trade credit insurance is not a substitute for transferring risk.
The business must have prudent, thoughtful credit management, and sound
credit management practices in place before a trade credit insurance policy can
be bound.
The process of insuring accounts receivable must, by definition, involve a
thorough understanding of a supplier’s trade sector, risk philosophy, business
strategy, financial health, funding requirements, and internal credit management
processes. It should be expected that the trade credit insurer will, at a minimum,
need the following basic information about the supplier’s business:
• A listing of the supplier’s top 10 to 20 buyers, broken down by country if
applicable;
• A list of all the countries to which the supplier is selling goods and services;
• Full details of the supplier’s credit management and collection procedures;
• Full details of the aged accounts receivables covering the previous 12 month’s
trading; and
• Three year’s history of buyer delinquencies and credit losses.
The goal is not simply to indemnify losses incurred from a trade debt default, but
to help the insured avoid catastrophic losses and grow their business profitably. It
is therefore critical that the insurer has the right information to make informed
credit decisions and thus avoid or minimize losses. A trade credit insurance policy,
therefore, does not replace but supplements a supplier’s credit processes.
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Unlike other types of business insurance, once a supplier purchases trade credit
insurance, the policy does not get filed away until next year’s renewal, but rather
the relationship becomes dynamic. A trade credit insurance policy can change
often over the course of the policy period, and the supplier’s credit manager plays
an active role in that process. Most trade credit insurers will individually analyze
the supplier’s larger buyers and assign each of them a specific credit limit. This is
where the type and amount of information the insurer has on a buyer, or is
provided by the supplier, plays a very important role in setting and monitoring the
credit limits.
Throughout the life of the policy, the supplier may, for example, request
additional coverage on an existing buyer. The trade credit insurer will investigate
the risk of increasing the credit limit and will either approve the requested higher
limit or decline with a written explanation. Similarly, suppliers may request
coverage on a new buyer with whom they would like to do business.
1.6
A process Note & Flow on Buyer Underwriting for better understanding: -
Approach Buyer underwriting forms a key aspect of Risk Management for trade credit insurance and is performed by the Risk Underwriting Team. This team functions within the defined boundaries of the Guidelines of the insurance company and should have a balanced approach to support the requirement of the Insured while maintaining responsibility towards the interest of the insurance company.
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Process Flow
Insured
Insurer
Buyer Identification The first step is to establish the correct entity on which the limit is requested based on the information provided by the insured. In case the buyer is un-identifiable, the request is rejected, and correct information is sought from the insured. Buyer Assessment The insurer may (but not restricted to) consider the below parameters while assessment of the buyer:
Buyer limit request
No Identification
Buyer Assessment
Yes
Positive
Negative
Limit Approval
Refusal
Refusal
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Quantitative Analysis- Financial parameters related to the buyer • Scale of operation & trend analysis like Turnover, Profitability, Net Worth, Cash
Flow • Ratio Analysis like Profitability Ratio, Liquidity Ratio, Solvency Ratio, Activity
Ratio • External Credit Rating Qualitative Analysis - Non-Financial parameters related to the buyer • Constitution/ Legal Status • Business vintage, management skills & group support • Trading History with Insured, years of relationship and dependency • Business activity & sector performance • Past payment behavior or loss experience • Adverse information or News in Public Domain Limit Approval Based on the assessment an internal Credit Rating is assigned and credit limit decision is taken. The insurer may approve the limit fully/ partially or refuse the limit. For a greater operational flexibility an insurer can fix a maximum permissible exposure amount (may be called Overall Limit, OL) on the buyer based on its creditworthiness assessment and the said exposure amount can be distributed among multiple policy holders in the form of Credit Limit(CL) suiting individual requirement. The insured during the policy period has the flexibility to request for modification of buyer limit or addition of fresh buyer. Limit Monitoring One of the critical aspects of the Buyer Underwriting process is continuous monitoring of the buyer portfolio. The exposure is monitored at buyer as well as on group level. In case of any claim or overdue reported on a buyer by any insured, the total limits under all policies are cancelled.
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1.7
It is also the trade credit insurer’s responsibility to proactively monitor its
customers’ buyers throughout the year to ensure their continued
creditworthiness. This is achieved by gathering information about buyers from a
variety of sources, including: visits to the buyer, public records, information
provided by other suppliers that sell to the same buyer, receipt of the most recent
financial statements, and so on. When it becomes knowledge that a buyer is or
may be experiencing financial difficulty, the insurer notifies all suppliers that sell
to that buyer of the increased risk and establishes an action plan to mitigate and
avoid loss. The goal of a trade credit insurance policy is not to simply pay claims as
they arise, but also to help suppliers avoid foreseeable losses. If an unforeseeable
loss should occur, the indemnification aspect of the trade credit insurance policy
comes into effect.
In these cases, the supplier would file a claim with the trade credit insurer,
including the required supporting documentation, and after the expiry of the
applicable waiting period, the trade credit insurer would pay the supplier the
amount of the indemnified loss.
However, it should be understood that trade credit insurers do not cover losses
where there is a valid dispute between the supplier and the buyer as to the
quality of the goods and services provided, for example, where the goods are
found to be damaged on delivery. For a supplier to have a valid claim against the
insurer, it must have a valid and legally enforceable debt against the buyer that
can be assigned to the insurer. Until the dispute has been finally settled in favor
of the supplier it will not be considered an insured sale. In the case of insolvency
this means that the supplier must obtain a written acknowledgement from the
receiver that it has recognized and accepted the debt.
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Trade credit insurance can be an excellent risk management tool for many
companies, but it may not be applicable to the following types of suppliers:
• Retailers—Trade credit insurance only covers business-to business accounts
receivable and not retail sales;
• Suppliers that sell to their group entities;
• Suppliers that sell exclusively to governments; and
• Suppliers that do not sell on open account terms.
For the most part, however, any supplier that conducts business-to-business
trade transactions is essentially already investing in a trade credit insurance
program. This investment is the sum of the costs associated with the supplier’s
risk philosophy, sales avoided, systems, credit/financial information, accounts
receivable management, losses incurred, collection and insolvency management.
All these are real costs and should be weighed against the cost associated with
outsourcing many of these functions to a competent trade credit insurer and the
benefits the supplier would derive from such a relationship.
In the face of the global recessionary climate, increased business failures both
domestically and globally, and the tightening of credit across the board, business
suppliers must be ever more vigilant regarding the management of their accounts
receivable. A trade credit insurance policy, if used properly, provides a valuable
extension to a company’s credit management practices—a second pair of
objective eyes when approving buyers, as well as an early warning system should
things begin to decline so that existing exposure can be effectively managed. Not
forgetting that should an unexpected loss occur, the trade credit insurance policy
provides indemnification, thus protecting the policyholder’s revenues, profits,
balance sheet and employees from what could otherwise be a financially
catastrophic event. By maintaining a strong relationship between the insurer and
the credit management department, trade credit insurance may be the wisest
26
investment a company can make to ensure its profits, cash flow, capital and
employment are protected.
1.8
Alternative Products
Trade credit insurance competes both with bank letters of credit as well as
factoring / invoice discounting. Table 1 below provides an overview of the two
main products and their features.
Letters of credit
A documentary letter of credit is a bank’s agreement to guarantee the payment of
a buyer’s obligation up to a stated amount for a specified period. Unlike trade
credit insurance, the buyer must approach the bank to request a letter of credit,
which has the disadvantage of reducing the buyer’s borrowing capacity as it is
charged against the overall credit limit set by the bank. In developing markets, it
may need to be cash secured. A letter of credit will only cover a single trans-
action for a single buyer whereas trade credit insurance usually covers all
supplier’s shipments to all of its buyers. As a letter of credit is for a single
transaction for a single buyer, it is normally more expensive than trade credit
insurance, both in terms of absolute cost and in terms of credit line usage with
the additional need for security.
Factoring
Receivables form a major part of the current assets of a company and
management of such receivables is the most important concern for the company.
Factoring is a financial option for the management of receivables. It is a tool to
obtain quick access to short-term financing and mitigate risks related to payment
delays and defaults by buyers. In the process of factoring, the seller sells its
receivables to a financial institution (“Factor”) at a discount. After the sale, there
27
is an immediate transfer of ownership of the receivables to the factor. In the due
course of time, either the factor or the company, depending upon the type of
factoring, collects payments from the debtors.
Factoring is a traditional product that allows a supplier to pre-finance its
receivables whereby the factor pays a percentage of the face value of the
receivables based upon its assessment of the credit risk and the underlying
payment terms. Consequently, it is more expensive than trade credit insurance. It
may be either non-recourse factoring, or full recourse factoring whereby the
factor will reclaim the money from the supplier if the buyer does not pay.
Trade credit insurance and factoring both complement and substitute for each
other. Where full recourse factoring is used, then it is in the best interests of both
the supplier and the factor for the supplier to purchase trade credit insurance,
and where it is non-recourse factoring then the factor may itself purchase trade
credit insurance to protect themselves against non-payment by the buyer.
Table 1: Trade credit insurance and its substitutes
Feature
Credit insurance
Letter of Credit Factoring without recourse
Risk Cover
Insolvency, protracted
default and
political risks
Buyer default Insolvency and protracted
default
Ancillary
Services
Credit information,
risk assessment,
market intelligence,
debt collection
None Debt collection and credit
information
28
Financing None, but facilitates
financing None
Converts trade receivables
into cash at a discount
Client
relations
Buyer is unaware of
credit insurance
contract
Buyer initiates
provision of
letter of credit
Collection by factor of trade
receivables may affect
client relations
Sources: -
Trade Credit Insurance by Peter M Jones-
http://siteresources.worldbank.org/FINANCIALSECTOR/Resources/Primer15_TradeCreditInsura
nce_Final.pdf
29
CHAPTER – 2
Credit Insurance Landscape – Global & India
2.1
Credit Insurance Landscape – Global
The market for credit insurance globally has been segmented based on
components into two major segment including products and services. The
companies operating in the global credit insurance market design and innovate
robust products and services depending upon the requirements of the customers
or clients.
The global credit insurance market is further bifurcated on basis of enterprise size
as small & medium enterprises (SMEs) and large enterprises. The large
enterprises capture a significant market share in the global credit insurance
market over the years. The different types of applications of credit insurance
includes domestic trading market and export trading market. The export segment
in the application is much more prominent and the demand for credit insurance
products and services are gaining importance in the domestic market in the
current years.
The global market for credit insurance is categorized on basis of five strategic
regions namely; North America, Europe, Asia Pacific, Middle East and Africa, and
South America. Geographically, the two most dominant region in the current
market scenario accounted for Europe and North America.
With the increase in small & medium trading enterprises across the globe, the
market for credit insurance market is expected to be fuelled by the SMEs
segment. The small and medium business enterprises across the globe frequently
encounters related to its account receivables according to the plans made while
30
exporting or trading in domestic and international market. The non-payment of
invoices effects the bottom line of these small and medium enterprises. This risk
is constantly growing across geographies and the enterprises are looking for
robust solutions to get rid of the threat. This is the reason behind rising attraction
towards credit insurance among the small and medium enterprises in developed
countries and few developing countries.
The global market for credit insurance is expected to exhibit high growth in near
future. Some of the major driving factors contributing to the market growth
includes the global macro-economic instability, which is posing a severe
commercial threat to the trader, thereby, increasing the adoption of credit
insurance.
However, the growth of global market for credit insurance accounted for several
fraudulent cases related to insurance claims from both the policyholders as well
as the insurance underwriters. These fraudulent cases have restricted the
adoption of the credit insurance sector among the small and medium enterprises
(SMEs) in the developing economies across the globe.
Nonetheless, economically stable countries in Asia Pacific region such as China,
India, Singapore, Australia, and Malaysia among others pose a substantial market
opportunity in the coming years.
2.2
There are largely two global association (ICISA & Berne Union) where Trade Credit
Insurers & Reinsurers as members keep publishing their data related to the
business done, claims & their exposure on the markets. This data gives us a deep
insight on how Trade Credit Insurers help businesses by protecting the risk arising
form failure of being paid.
31
ICISA (International Credit Insurance & Surety Association) has a mix of both
private players & the ECAs (Export Credit Agencies).
Berne Union has more ECAs & reinsurers as their members.
Please note that short term trade credit (ST), dominates the statistics, accounting
for 90% of total new business underwritten. Medium / Long-term (MLT) export
credit insurance accounts for 8% and investment insurance just 2%
32
33
34
35
36
2.3
There are instances where Governments are trying to support business with
Credit Insurance as well as worked to tweak regulations a bit to maintain the
overall governance of Credit Insurance Sector as well.
SINGAPORE GOVERNMENT SUPPORT:
There are 2 schemes under which the Govt of Singapore supports SME sector to
help them absorb part of premium paid.
1). Trade Credit Insurance Scheme (TCIS)
The Trade Credit Insurance Scheme (TCIS) defrays the cost of insurance for
companies by supporting part of the minimum premium payable.
Benefit
If your company qualifies, Enterprise Singapore can support up to 50% of the
minimum insurance premium for TCI policies provided commercially by
Singapore-registered credit insurers. This is subject to a maximum lifetime
support of S$100,000 per qualifying Applicant Company.
2). Political Risk Insurance Scheme (PRIS)
Political risks insurance (PRI) is an important tool for companies to safeguard their
projects and/or investments in overseas markets against political uncertainties.
Companies can also use PRI to unlock access to mid to long-term financing as it
gives lenders additional assurance that the impact of political uncertainties over
the performance of a project or investment has been mitigated.
37
With Political Risk Insurance Scheme (PRIS), qualifying Singapore companies can
receive premium support for PRI policies. Enterprise Singapore will support 50%
of the premium for up to the first three years of each PRI policy. This is subject to
a maximum amount of S$500,000 per qualifying Singapore-based company.
2.4
CHINA REGULATIONS ON CREDIT INSURANCE:
China Banking & Insurance Regulatory Commission (“CBIRC”) issued on 11 July
2017 new ‘Regulations Governing Credit Insurance Business’ (the “Regulations”)
in order to strengthen macro governance of the Credit Insurance sector.
The Regulations now require that in order to write Credit Insurance business,
China insurers must:
ensure that at any given time, their gross retained liability/exposure to
Credit Insurance risk does not exceed ten times such insurer’s net asset
value, as measured at the end of the previous quarter, with any retained
exposure in excess of this amount to be reinsured off such insurer’s books;
ensure that the retained exposure to any single Credit Insurance insured
(singly or as an affiliated group) does not exceed 5% of such insurer’s net
asset value, as measured at the end of the previous quarter, with any
retained exposure in excess of this amount to be reinsured off such
insurer’s books; and
not offer or underwrite Credit Insurance for any online lending platform
operator, unless such online lending platform operator is duly licensed and
fully compliant with all online lending regulations.
38
2.5
Credit Insurance Landscape – India
Credit Insurance in India started way back in 1957 when Government of India
decided to setup the Indian ECA (ECGC) to promote Exports from our country
supporting the business & Economy.
Post that when the Insurance Sector was opened in 1999 after IRDA was created,
lot of public as well as private players are doing this business regularly though the
business is slowly picking up compared to other lines of Insurance Business.
Players in Indian Market: -
ECGC: ECGC Ltd. (Formerly Export Credit Guarantee Corporation of India Ltd.),
wholly owned by Government of India, was set up in 1957 with the objective of
promoting exports from the country by providing Credit Risk Insurance and
related services for exports. It functions under the administrative control of
Ministry of Commerce & Industry and is managed by a Board of Directors
comprising representatives of the Government, Reserve Bank of India, banking,
and insurance and exporting community. Over the years it has designed different
export credit risk insurance products to suit the requirements of Indian exporters
and commercial banks extending export credit.
ECGC is essentially an export promotion organization, seeking to improve the
competitiveness of the Indian exporters by providing them with credit insurance
covers. ECGC keeps its premium rates at the optimal level.
NEW INDIA: Though ECGC was offering Credit Insurance to exporters to cover
their sales since 1957, there was no product available in India to cover domestic
sales. The New India Assurance Co. Ltd introduced domestic Credit Insurance in
India, vide their product “Business Credit Shield” in September 2001. Though the
39
product was approved by IRDAI in May 2001, it was formally inaugurated by then
Finance Minister Mr. Yeshwant Sinha in Sept 2001.
Other Players: -
SBI GIC
IffcoTokioGIC
Tata AIG GIC
ICICI Lombard GIC
HDFC ERGO GIC
Bajaj ALLIANZ GIC
Bharti AXA GIC
Universal Sompo GIC
Future Generali GIC
United India
National Insurance
2.6
Total INDIA Premium: -
Credit Insurance Premium incl ECGC (Source: IRDAI)
Year Premium in Cr
2018-19 1525.21
2017-18 1476.98
2016-17 1467.90
40
Premium player Wise
"Credit" LoB GDP (Source: IRDAI)
in Rs Crores
S. No Insurer 2016-17 2017-18 2018-19
1 ECGC 1267.61 1240.41 1247.54
2 ITGI 73.20 72.69 86.31
3 ICICI Lombard 33.57 44.01 41.13
4 Tata Aig 25.68 32.71 42.15
5 Bajaj Allianz 16.26 13.85 10.68
6 SBI GIC 9.32 13.02 18.84
7 New India 32.27 36.96 42.11
8 HDFC Ergo 6.05 19.19 31.65
9 Bharti Axa 2.96 3.12 2.91
10 Raheja QBE 0.76 1.02 1.90
11 Universal Sompo 0.21 0.00 0.00
12 UIIC 0.00 0.00 0.00
Grand Total 1467.9 1476.99 1525.22
"Credit" LoB GDP excluding ECGC
in Rs Crores
S. No Insurer 2016-17 2017-18 2018-19
1 ITGI 73.20 72.69 86.31
2 ICICI Lombard 33.57 44.01 41.13
3 Tata Aig 25.68 32.71 42.15
41
4 Bajaj Allianz 16.26 13.85 10.68
5 SBI GIC 9.32 13.02 18.84
6 New India 32.27 36.96 42.11
7 HDFC Ergo 6.05 19.19 31.65
8 Bharti Axa 2.96 3.12 2.91
9 Raheja QBE 0.76 1.02 1.90
10 Universal Sompo 0.21 0.00 0.00
11 UIIC 0.00 0.00 0.00
Grand Total 200.29 236.58 277.68
2.7
The genesis of the inherent contradiction can be traced back to the first set of
guidelines on trade credit insurance released in December 2010
(IRDA/NL/PR/CRE/208/12/2010). The Authority at that time, concerned and
alarmed with global crisis, economic slowdown, looming claims, widespread mis-
selling & frauds stop the product in the existing framework & relaunch it with
stringent guidelines. These guidelines were applicable to all insurance companies
doing Credit Insurance Business except ECGC.
The key guidelines were: -
Policy cannot be issued to Banks / FIs
No Assignment of Policies
No factoring / Bill discounting or similar arrangement to be covered.
Only whole turnover policies
No Single Buyer Policy
Indemnity at 80%
All buyers contributing more than 2% of the total turnover to be
compulsory assessed.
No govt or para govt buyers to be covered
42
In 2016 (IRDA/NL/CIR/CRE/044/03/2016), IRDA revisited the guidelines to provide
relief to the industry. The major changes were: -
Assignment of proceeds of the claim was permitted
Flexibility in whole turnover in terms of Segment/Country permitted
Indemnity increased to 85%
The cap on min number of 10 buyers was lifted.
There were still further gaps which were required to be addressed. Between 2016
– 2019, various industry bodies like Banks, Factoring Companies, Trade
Associations, Insurers & Brokers represented their wishes to the regulator to
ensure maximum utilization of the product at par with Global Standards for the
benefit of the policy holders.
In today’s context, effective norms have been framed in the area of AML & KYC.
Also, Government of India has prepared the ground for the next generation
reforms in banking and supporting Indian business, with strong focus on SMEs
and MSMEs. The passage of various acts like
Factoring Regulations act 2011
RBI regulations 2013 to allow a special category as NBFC-Factors
Specific guidelines from Regulators with/without Recourse Factoring –
2014,2015,2016
Formation of Credit Guarantee Fund (NCGTC) 2014 budget (which is under
implementation by Ministry of Finance and SIDBI
Creation of TReDS (Trade receivables Discounting Exchange) 2015-16
Insolvency and Bankruptcy Code (IBC), 2016
Implementation of E-way bills and proposed e-invoicing system will reduce
domestic trade malpractices in large extend
43
Automated process of cautioning / de-cautioning of exporters through
EDPMS system will arrest malpractices in export business
Availability of robust credit bureaus information’s
With the above reforms, including a unified tax structure by way of the goods and
service Tax, paves way for a conducive business environment for SMEs and
MSME’s.
44
Chapter – 3
Factoring
3.1
The Factoring Act, 2011 defines the ‘Factoring Business’ as “the business of
acquisition of receivables of assignor by accepting assignment of such receivables
or financing, whether by way of making loans or advances or in any other manner
against the security interest over any receivables”. However, credit facilities
provided by banks in the ordinary course of business against security of
receivables and any activity undertaken as an agent or otherwise for sale of
agricultural produce or goods of any kind whatsoever and related activities are
expressly excluded from the definition of Factoring Business. The Factoring Act
has laid the basic legal framework for factoring in India.
NBFC-Factor means a non-banking financial company fulfilling the Principal
business criteria i.e. whose financial assets in the factoring business constitute at
least 75 percent of its total assets and income derived from factoring business is
not less than 75 percent of its gross income, has Net Owned Funds of Rs. 5 crore
and has been granted a certificate of registration by RBI under section 3 of the
Factoring Regulation Act, 2011.
Every company registered under Section 3 of the Companies Act 1956 seeking
registration as NBFC-Factor shall have a minimum Net Owned Fund (NOF) of Rs. 5
crore. Existing companies seeking registration as NBFC-Factor but do not fulfil the
NOF criterion of Rs. 5 crore may approach the Bank for time to comply with the
requirement.
A company shall have to submit to RBI, a letter of its intention either to become a
Factor or to unwind the business totally, and a road map to this effect. The
company would be granted CoR as NBFC-Factor only after it complies with the
45
twin criteria of financial assets and income. If the company does not comply
within the period as specified by the Bank, it would have to unwind the factoring
business.
An entity not registered with the Bank may not conduct the business of factoring
unless it is an entity mentioned in Section 5 of the Act i.e. a bank or any
corporation established under an Act of Parliament or State Legislature, or a
Government Company as defined under section 617 of the Companies Act, 1956.
Under Section 19 of the Factoring Act, 2011 every Factor is under obligation to file
the particulars of every transaction of assignment of receivables in his favour with
the Central Registry to be set-up under section 20 of the Securitization and
Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
(54 of 2002), within a period of thirty days from the date of such assignment or
from the date of establishment of such registry, as the case may be.
NBFC-Factors undertaking import & export factoring will need to obtain the
necessary authorization from the Foreign Exchange Department of the Bank
under FEMA 1999 as amended and adhere to all the FEMA regulations in this
regard.
3.2
Export Factoring: - Export factoring is a financing solution available to the
exporter which allows the exporter to offer open account terms, a better liquidity
position and allows it to be increasingly competitive. It can also be viewed as an
alternative to export credit insurance, long-term bank financing or other high cost
debt.
Export factoring allows trade to be carried out on open account terms and assists
especially where there are short-term sales of products and where there may
be risk of non-payment. It eases the credit and collection troubles in case of
46
international sales and accelerates cashflows thereby assisting in credit risk
mitigation and provides liquidity in the business.
Export factoring bundles together credit protection, export working capital
financing, foreign accounts receivables bookkeeping and collection services- all in
one product. It is the sale of foreign accounts receivable by a seller (exporter) to a
factoring company at a discount, where the financier (factor) assumes the risk of
default of the foreign buyer and handles collection on the receivables. The factor
will purchase the accounts receivables or invoices, which are raised once the
exporter ships the goods to the buyer (importer). Export financing is usually
without recourse wherein the financier takes the payment risk of the importer.
47
3.3
Domestic Factoring: - Domestic Factoring is a process of factoring of accounts
receivables generated out of sales within India. The Seller assigns to the Factor
the accounts receivables arising out of sales to buyers within the country on open
account terms and receives payment there against to the extent of 80-90% from
the Factor, depending upon the credit terms.
Steps in Domestic Factoring:
1. Customer ( Buyer) places the order with Client (Seller)
2. Client (Seller) obtains a prepayment limit from Factoring Company
3. Client (Seller) delivers goods/services to the customer (Buyer).
Our Client Client’s Buyer
Factoring Company
1.Ships Goods on Credit
Terms
Follows up with Buyer
48
4. Copies of Invoices, along with a Notice to Pay, are submitted to the
FactoringCompany.
5. Factoring Company makes a prepayment advance to the Client
6. Factoring Company follows up on payment with the Customer (Buyer)
7. Customer (Buyer) makes payment to Factoring Company
8. Factoring Company makes the balance payment to the Client (Seller), net of
charges.
3.4
India Export Market Size: -
FY’19 India exports were USD 330 Bn. The open account opportunity is approx
USD 70 Bn. Further clasiification country & product wise as classified in the chart.
49
3.5 Factoring & International Markets (FCI)
Factoring and Bill discounting started in early 19th Century, now have more than
100 years of expertise in domestic and export Receivables Insurance and
financing.
Globally Factoring volumes have crossed ~2300 Bn Euro and this availability and
penetration have contributed immensely to GDP growth for their respective
countries.
FCI (Factors Chain International) is the Global Representative Body
for Factoring and Financing of Open Account Domestic and International Trade
Receivables. With close to 400 member companies in 90 countries FCI offers a
unique network for cooperation in cross-border factoring.
In the members of FCI, Specialist Trade Credit Insurers like Euler Hermes are also
there supporting these Factoring companies with their knowledge to know more
the buyers & further protect them for any default of the same.
Factoring companies with the support of Credit Insurers do help small business
survive in terms of protection & availablity of financing to steer in their growth
which finally helps the overall economy.
The following data & charts are published figures of FCI members on their
Factoring Business Turnover.
50
FCI Members Accumulative Factoring Turnover vs Worldwide Factoring Turnover
in million EURO in 2018: -
51
FCI Members Domestic, International, Factoring & International Volume Data
52
Factoring Turnover by Country in 2018 in Millions of Euros: -
Please find the details of the factoring turnover by each country as mentioned in
FCI report 2018. The Indian Factoring Market is miniscule in terms of the economy
size vis-à-vis compared to even similar economies.
Globally Factoring companies take the support of Credit Insurance to increase
their support in lending to businesses thus extedning the credit line for SMEs.
53
54
55
3.6
Banks Trade Finance Products Insurance solution offered globally to
support banks
Sales Factoring Factoring Policy
Channel Finance Program Supply Chain Policy
Vendor/Purchase Financing Top Buyer covers
LC discounting/ Buyers Credit Purchase Finance Programs
SBLC backed funding LC/ SBLC Non-honour Covers
FACTORING VS BANK FINANCE: -
Factoring
Receivables are Assigned / Purchased
Factoring Limit - Off Balance Sheet (Non-Recourse)
Unsecured
Receivables get converted into Cash
Factoring Limit is based on future Sales
Factoring is based on Client’s performance of goods and Debtor’s Creditworthiness
Collection Services
No Penalty on Overdues
Buyer Concentration approach
Bank Finance
Receivables are Hypothecated
Bank Limit reflects on Balance Sheet as Loan
Mostly Secured
Receivables remain as Debtors
Bank Limit is based on Balance Sheet
Banking Limit is based on Client’s Creditworthiness
No Collection Services provided
Penal Interest on Overdue
Client Concentration approach
56
Factoring is an accepted method of receivables financing across the globe and is
regulated by a stringent set of rules and procedures. Initially, in India, factoring
was not a typical or mainstream financial service in the absence of legislation.
However, with the enactment of Factoring Regulation Act, the necessary legal
framework is now in place for factoring to gain traction. But unfortunately,
reservations on part of corporates and PSU buyers to accept assignment of
receivables made in favour of factors, issues with the legal system and dominance
of banks in factoring business have been hampering the growth.
Sources: -
RBI Website https://m.rbi.org.in/Scripts/FAQView.aspx?Id=88
IFC Factoring Figures 2018 https://fci.nl/downloads/Annual%20Review%202019.pdf
(https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=924) Report on
the expert committee on Micro Small and Medium Enterprises dated June
2019 Chaired by Shri U.K.Sinha
57
CHAPTER 4
Micro, Small & Medium Enterprises
4.1
MSMEs Snapshot In India:
• Number of MSMEs in India: The number is estimated to be 42.50 million,
registered & unregistered together. A staggering 95% of the total industrial
units in the country.
• MSMEs& Employment opportunity: Employs about 106 million, 40% of
India’s workforce. Next only to the agricultural sector.
• Products: Produces more than 6000 products.
• GDP Contribution: Currently around 6.11% of the Manufacturing Sector
GDP and 24.63% of Services Sector GDP
• MSMEs Output: 45% of the total Indian Manufacturing Output.
• MSMEs Exports: 40% of the total Exports.
• Bank Lending: Accounts for approx. 16% of Bank Lending.
• MSMEs Growth Rate: Consistent Average Growth Rate of over 10%.
India is one of the fastest growing economies of the world. In the last half-decade,
the economic growth has steadily accelerated and most importantly, remained
very stable. This growth has been driven by robust socio-economic policies of the
government, an influx in the domestic and foreign capital and rise in disposable
income and consumption among many other positive attributes.
The Indian MSME sector is the backbone of the national economic structure and
has unremittingly acted as the bulwark for the Indian economy, providing it
resilience to ward off global economic shocks and adversities. With around 63.4
million units throughout the geographical expanse of the country, MSMEs
58
contribute around 6.11% of the manufacturing GDP and 24.63% of the GDP from
service activities as well as 33.4% of India's manufacturing output. They have
been able to provide employment to around 120 million persons and contribute
around 45% of the overall exports from India. The sector has consistently
maintained a growth rate of over 10%. About 20% of the MSMEs are based out of
rural areas, which indicates the deployment of significant rural workforce in the
MSME sector and is an exhibit to the importance of these enterprises in
promoting sustainable and inclusive development as well as generating large
scale employment, especially in the rural areas.
4.2
The term MSME is widely used to describe small business often lacking formalized
institutional processes. Governments & financial Institutions around the world
have varied definitions for the sector – sometimes vary even between the public
& private sectors within the same country. Criteria often use to classify as an
MSME include number of employees, annual sales, total assets, type of assets,
urban or rural location of enterprise & their financial need.
In India, the government’s criteria for MSMEs is different from the definition the
World Bank follows – based solely on whether an enterprise is operating in a
manufacturing or service industry. MSMEs are classified based on their
investment in plant & machinery for a manufacturing enterprise or investment in
equipment for a service enterprise. This definition was established in the Micro,
Small & Medium enterprise development Act (MSMED Act) of 2006.
While there has been concern raised that this definition is outdated & does not
include enterprises that may be larger than the specified criteria but still face
similar challenges & conditions as MSMEs, the definition provided below is the
most widely accepted classification of MSMEs based on which policies for the
sector are created & implemented.
59
MSMED Act definitions of MSMEs
Just about 15% of the business in the sector are registered enterprises while the
huge balance is all unregistered. In order to encourage registration, the ministry
of Micro, Small & Medium enterprises has simplified the registration process,
replacing the earlier two-stage registration process with a one-step filling of
memorandum.
Even though the sector is classified into Micro, Small & Medium as defined by the
MSMED Act, almost 95% of the Sector comprises Micro Enterprises, 4.9% Small
Enterprises & 0.1% Medium enterprises.
Simultaneously, the ownership Structure accounting to 94% for all MSMEs
primarily is proprietorship because this structure requires lower legal overheads.
Ownership Structure Share of MSME Sector
Proprietorship 93.83%
Partnership 1.53%
Private Company 0.23%
Public Company 0.04%
Cooperative 0.13%
Other 4.24%
Classification
Manufacturing Enterprise –
Investment Limit in Plant & Machinery
Service Enterprise –
Investment Limit in Equipment
Micro INR 2.5 million (USD 40,000) INR 1 million (USD 15,000)
Small INR 50 million (USD 0.8 million) INR 20 million (USD 0.3 million)
Medium INR 100 million (USD 1.5 million) INR 50 million (USD 0.8 million)
60
4.3
Even though the small and medium-sized enterprises (SMEs) sector contributes to
a large chunk of India’s GDP, traditional inefficient methods of operating business
and the low rate of technology adoption has hindered smaller business to achieve
their potential.
However, despite its contribution to the socio-economic growth of India, SMEs
face a number of challenges:
Lack of capital due to inadequate access to finance and credit
Inability to attract talented and tech-savvy manpower
Poor infrastructure and utilities resulting in low production capacity
Lack of innovation
Technology and digital knowledge gap
Lack of marketing know-how
Due to these challenges, the Indian SMEs are unable to scale to their full
potential, rise up to the standards of their international peers and become self-
sustainable. On the positive side, these challenges should be perceived as
untapped opportunities for the SME sector. These challenges offer a broad scope
to strengthen the foundation of SMEs in India.
Micro, Small and Medium Enterprise (MSME) sector has emerged as a very
important sector of the Indian economy, contributing significantly to employment
generation, innovation, exports, and inclusive growth of the economy. Micro,
Small and Medium Enterprises (MSMEs) are amongst the strongest drivers of
economic development, innovation and employment.
India is currently one of the fastest growing economies of the world. MSME sector
is likely to continue to play a significant role in the growth of the Indian economy.
In the last ten years, MSME sector has shown impressive growth in terms of
61
parameters like number of units, production, employment, and exports. Given the
right set of support systems and enabling framework, this sector can contribute
much more, enabling it to actualize its immense potential.
4.4
Seven components of the MSME ecosystem: -
Pillar Description
Human Capital Development Enabling entrepreneurship and skill development
to build human capital for the sector
Knowledge Dissemination Enabling one-stop information sources to resolve
information asymmetry
Access to Finance including
Insurance
Enabling timely access to credit and insurance
products
Access to Technology Enabling development of emerging technology
ecosystem
Common Facility Infrastructure Enabling incubation, plug and play facilities in
major clusters
Facilitating Access to Markets Enabling improved access to markets including
digital marketing enablement
Policy Governance and Ease of
Doing Business Enabling responsive policy formulation
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4.5
MSME Credit Demand and Gap Estimates:
In India, the total addressable demand for external credit is estimated to be37
trillion while the overall supply of finance from formal sources is estimated to be
₹14.5 trillion Therefore, the overall credit gap in the MSME sector is estimated to
be ₹20 – 25 trillion.
At an aggregate level, the banking sector has credit outstanding to MSMEs of
approximately ₹17.4 trillion as on March 31, 2019. SCBs account for 90% of the
share of this, although NBFCs have grown at a healthy rate in recent years.
The micro segment (<1cr is the fastest growing segment and accounts for
₹4.3 lakh crore out of the total of ₹14.3 lakh crore outstanding MSME
credit). This segment grew at 22% y-o-y in 2018. This segment also exhibits
the lowest NPAs, although in absolute terms still high at 8.5%.
As per RBI data, the share of NBFCs in outstanding credit to MSME was
9.3% in March 2019. This trend is expected to accelerate with the
emergence of FinTech (typically registered as NBFCs) focused on this
segment.
Share of NBFCs in outstanding credit to Medium enterprises has also
become significant. As of March 2018, credit from NBFCs was 17% of the
total credit extended by SCBs and NBFCs to Medium enterprises, as per RBI
data.
Barriers to MSME Lending and Late Payment Issues
Despite an ongoing policy focus, growth of MSME credit has been weak. MSMEs
lack access to formal credit as banks face challenges in credit risk assessment of
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MSMEs on account of lack of financial information, historical cash flow, etc. Years
of mandated lending have not produced enough progress and new approaches
are needed. At an overall level, India’s banking system is still small relative to the
needs of the real sector. Against this backdrop, MSMEs find it challenging to
access adequate credit. First, the risk in lending to MSME sector are high as the
risks in turn can be traced to inability to pay and unwillingness to pay. The former
can in turn be traced to business risk factors such as delayed buyer payments
embedded in supply chains or supplying to Government entities and also other
business risks, including changes in consumer demand or extraneous events that
create a slow-down in the market. MSMEs often have little to no equity buffers.
MSEs face problems of delayed payments and hesitate to enforce the legal
provisions available to them under the MSMED Act due to their low bargaining
power. MSEs face problems of delayed payments because of low bargaining
power not only from corporates but also from PSUs and Government Agencies,
both Central and State which adversely affects their working capital
cycle/requirements and ultimately affects their operational efficiency. As timely
payments to MSEs is of least priority to the buyers, the solution must be
necessarily designed around the buyers.
4.6
Trade Receivables Discounting System (TReDS)
As per RBI, The scheme for setting up and operating the institutional mechanism
for facilitating the financing of trade receivables of MSMEs from corporate and
other buyers, including Government Departments and Public Sector Undertakings
(PSUs), through multiple financiers will be known as Trade Receivables
Discounting System (TReDS).
The TReDS will facilitate the discounting of both invoices as well as bills of
exchange. Further, as the underlying entities are the same (MSMEs and corporate
and other buyers, including Government Departments and PSUs), the TReDS
64
could deal with both receivables factoring as well as reverse factoring so that
higher transaction volumes come into the system and facilitate better pricing. The
transactions processed under TReDS will be “without recourse” to the MSMEs.
Trade Receivables Discounting System (TReDS) RBI introduced TReDS in 2014 in
order to solve the problem of delayed payments to MSMEs, TReDS is an electronic
platform where receivables of MSMEs drawn against buyers (large corporates,
PSUs, Government Departments, etc.) are financed through multiple financiers at
competitive rates through an auction mechanism. Presently, three entities viz.,
Receivables Exchange of India Ltd. (RXIL), A. TREDS, and Mynd Solutions licensed
by RBI are operating the platform for more than two years. The summary of
traction gained on the TReDS platform as on March 31, 2019 is given in Table XIX
below:
65
Leveraging TReDS Platform Ecosystem for Credit Insurance:
Illustrative Outline of Process flow under TReDS
a) Corporate and other buyers, including Government Departments and Public
Sector Undertakings, send purchase order to MSME seller (outside the purview
of the TReDS).
b) MSME seller delivers the goods along with an invoice. There may or may not be
an accepted bill of exchange depending on the trade practice between the
buyer and the seller (outside the purview of the TReDS).
c) Thereafter, on the basis of either an invoice or a bill of exchange, the MSME
seller creates a ‘factoring unit’ (which would be a standard nomenclature used
in the TReDS for an invoice or a bill on the system) on TReDS. Subsequently,
the buyer also logs on to TReDS and flags this factoring unit as ‘accepted’. In
CREDIT INSURANCE to be provided to Financier against default of Buyer on TReDS
Exchange. Policy per transaction to be issued by Exchange.
66
case of reverse factoring, this process of creation of factoring unit could be
initiated by the buyer.
d) Supporting documents evidencing movement of goods etc. may also be hosted
by the MSME seller on the TReDS in accordance with the standard list or
check-list of acceptable documents indicated in the TReDS.
e) The TReDS will standardize the time window available for buyers to ‘accept’ the
factoring units, which may vary based on the underlying document – an invoice
or bill of exchange.
f) The TReDS may have either a single or two separate modules for transactions
with invoices and transactions with Bills of Exchange, if so required. In either
case, all transactions routed through TReDS will, in effect, deal with factoring
units irrespective of whether they represent an invoice or a bill of exchange.
g) Factoring units may be created in each module as required. Each such unit will
have the same sanctity and enforceability as allowed for physical instruments
under the “Factoring Regulation Act, 2011” or under the “Negotiable
Instruments Act, 1881”
h) The standard format / features of the ‘factoring unit’ will be decided by the
TReDS – it could be the entire bill/invoice amount or an amount after
adjustment of tax / interest etc. as per existing market practice and as adopted
as part of the TReDS procedure. However, each factoring unit will represent a
confirmed obligation of the corporate and other buyers, including Government
Departments and PSUs, and will carry the following relevant details – details of
the seller and the buyer, issue date (could be the date of acceptance), due
date, tenor (due date – issue date), balance tenor (due date – current date),
amount due, unique identification number generated by the TReDS, account
details of seller for financier’s reference (for credit at the time of financing),
account details of buyer for financier’s reference (for debit on the due date),
the underlying commodity (or service if enabled).
i) The TReDS should be able to facilitate filtering of factoring units (by financiers
or respective sellers / buyers) on any of the above parameters. In view of the
67
expected high volumes to be processed under TReDS, this would provide the
necessary flexibility of operations to the stakeholders.
j) The buyer’s bank and account details form an integral feature of the factoring
unit. The creation of a factoring unit on TReDS shall result in automatic
generation of a notice / advice to the buyer’s bank informing them of such
units.
k) These factoring units will be available for financing by any of the financiers
registered on the system. The all-in-cost quoted by the financier will be
available on the TReDS. This price can only be viewed by the MSME seller and
not available for other financiers.
l) There will be a window period provided for financiers to quote their bids against
factoring units. Financiers will be free to determine the time-validity of their bid
price. Once accepted by the MSME seller, there will be no option for financiers
to revise their bids quoted online.
m) The MSME seller is free to accept any of the bids and the financier will receive
the necessary intimation. Financiers will finance the balance tenor on the
factoring unit.
n) Once a bid is accepted, the factoring unit will get tagged as “financed” and the
funds will be credited to the seller’s account by the financier on T+2 basis (T
being the date of bid acceptance). The actual settlement of such funds will be
as outlined under the Settlement section.
o) Once an accepted factoring unit has been financed by a financier, notice would
be sent to buyer’s bank as well as seller’s bank. While the buyer’s bank would
use this information to ensure availability of funds and also handle the direct
debit to the buyer’s account on the due date in favour of the financier (based
on the settlement obligations generated by the TReDS), the seller’s bank will
use this input to adjust against the working capital of the MSME seller, as
necessary (the TReDS procedures may, if necessary, also indicate that the
proceeds of the accepted and financed factoring units will be remitted to the
68
existing working capital / cash credit account of the MSME seller). If agreed by
members, the TReDS may also provide the option to members, whereby the
financiers would take direct exposure against the buyers rather than through
their bankers.
p) On the due date, the financier will have to receive funds from the buyer. The
TReDS will send due notifications to the buyers and their banks advising them
of payments due. The actual settlement of such funds will be as outlined under
the Settlement section.
q) Non-payment by the buyer on the due date to their banker should tantamount
to a default by the buyer (and be reported as such as per regulatory
procedures prescribed from time to time) and enable the banker to proceed
against the buyer. Any action initiated in this regard, will be strictly non-
recourse with respect to the MSME sellers and outside the purview of the
TReDS.
r) These instruments may be rated by the TReDS on the basis of external rating of
the buyer, its credit history, the nature of the underlying instrument (invoice or
bill of exchange), previous instances of delays or defaults by the buyer with
respect to transactions on TReDS, etc.
s) The rated instruments may then be further transacted / discounted amongst
the financiers in the secondary segment.
t) Similar to the primary segment, any successful trade in the secondary segment
will also automatically result in a direct debit authority being enabled by the
buyer’s bank in favour of the financier (based on the settlement obligations
generated by the TReDS). In parallel, it will also generate a ‘notice of
assignment’ intimating the buyer to make the payment to the new financier.
u) In the event that a factoring unit remains unfinanced, the buyer will pay the
MSME seller outside of the TReDS.
69
In order to meet the requirements of various stakeholders, the TReDS should
ensure to provide various types of MIS reports including intimation of total
receivables position, financed and unfinanced (to sellers); intimation of
outstanding position, financed and unfinanced with details of beneficiaries and
beneficiary accounts to be credited (for buyers); total financed position for
financiers; etc. Similarly, data on unfinanced factoring units in the market should
also be made available by the TReDS. The system should also generate due date
reminders to relevant parties, notifications to be issued to bankers when a
factoring unit is financed, notifications to be issued to buyers once a factoring unit
related to their transaction is traded in the secondary segment, etc.
Sources: -
Financing India’s MSMEs - (https://www.ifc.org/wps/wcm/connect/dcf9d09d-68ad-4e54-b9b7-
614c143735fb/Financing+India%E2%80%99s+MSMEs+-
+Estimation+of+Debt+Requirement+of+MSMEs+in+India.pdf?MOD=AJPERES&CVID=my3Cmzl)
https://www.nasscom.in/about-us/what-we-do/industry-development/sme-landscape
https://www.cii.in/Sectors.aspx?enc=prvePUj2bdMtgTmvPwvisYH+5EnGjyGXO9hLECvTuNuXK6
QP3tp4gPGuPr/xpT2f
msme.gov.in/KPMG/CRISIL/CII
https://m.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=3504
70
CHAPTER – 5
Trade Credit Guidelines Recommendations
EXISTING GUIDELINES PROPOSED CHANGES COMMENTS
I Definitions
A "Buyer" means any
person/business entity, who is
liable to pay policy-holder, for
a trade credit transaction on
open and agreed terms.
"Buyer" means any business
entity, who is liable to pay
policy-holder, for a trade credit
transaction on open and
agreed terms.
Individual Person cannot be a
buyer.
B "Credit Limit" is the credit
limit set by the insurer for
every buyer with whom the
policy holder trade. The level
of the limit is set at the
maximum amount in normal
circumstances that can be
owed by the buyer at any
time. Limits shall be assessed
by seller applying principles of
prudence and granted at a
suitable level, depending on
the creditworthiness of the
buyer.
"Credit Limit" is the credit limit
set by the insurer for every
buyer with whom the policy
holder trade. The level of the
limit is set at the maximum
amount of exposure acceptable
to insurer in normal
circumstances in respect of the
amount owed by the buyer at
any time. Limits shall be
assessed by seller applying
principles of prudence and
granted at a suitable level,
depending on the
creditworthiness of the buyer.
Modified to have better clarity
C "Factoring" means the
business of acquisition of
receivables of assign or by
accepting assignment of such
receivables or financing,
whether by way of making
loans or advances or
otherwise against the security
interest over any receivables
Continue with the existing
definition.
71
D "Financial Guarantee" is
understood as comprising any
bond, guarantee, indemnity or
insurance, covering financial
obligations in respect of any
type of loan, personal loan
and leasing facility, granted by
a bank/credit institution,
financial institution or
financier, or issued or
executed in favour of any
person or legal entity in
respect of the payment or
repayment of borrowed
money or any contract,
transaction or arrangement -
primary purpose of which is to
raise finance or secure sums
due in respect of borrowed
money.
"Financial Guarantee" as
defined by ICISA is understood
as comprising any bond,
guarantee, indemnity or
insurance, covering financial
obligations in respect of any
type of loan, personal loan and
leasing facility, granted by a
bank/credit institution,
financial institution or
financier, or issued or executed
in favour of any person or legal
entity in respect of the
payment or repayment of
borrowed money or any
contract, transaction or
arrangement - primary purpose
of which is to raise finance or
secure sums due in respect of
borrowed money &
amendments thereof.
E "Granted credit limit" is the
maximum insured credit line
for a specific buyer and the
policy holders can trade on an
insured basis within the
approved credit limit
throughout the policy period
without further reference to
the insurer.
Continue with the existing
definition.
F "Insolvency (Bankruptcy)" A
judicial or administrative
procedure where by the
assets and affairs of the buyer
are made subject to control or
supervision in the jurisdiction
defined under the policy by
the court or a person or body
appointed by the court or by
law, for the purpose of
reorganization or liquidation
of the buyer or of the
rescheduling, settlement or
Continue with the existing
definition.
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suspension of payment of its
debts.
G "Maximum liability amount"
is maximum loss that can be
sustained through one single
policy. If the total loss of a
policy occurring during the
policy year exceeds the
amount of the agreed
maximum liability, the actual
loss for this policy is limited to
this amount. The maximum
liability is often defined as a
multiple of the earned
premiums in a given policy
contract.
"Maximum liability amount" is
maximum loss that can be paid
under one single policy. If the
total loss of a policy occurring
during the policy year exceeds
the amount of the agreed
maximum liability, the
aggregate claim amount under
this policy is limited to this
amount.
Modified to have better clarity
H "Reverse Factoring
arrangement" means any
arrangement in whatever
name or form, between a
borrower and a financer,
wherein a borrower receives
or is supposed to receive
finance, either directly or
indirectly, for borrower's
purchase of trade receivables,
goods or services.
Continue with the existing
definition.
I "Seller" means a person or
business entity who sells the
underlying goods or services,
for a trade credit transaction,
on open and agreed terms.
Continue with the existing
definition.
J "Trade Credit Insurance
business" means the business
of effecting contracts of
insurance in respect of trade
credit transactions.
Continue with the existing
definition.
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K "Trade credit insurance"
means insurance of suppliers
against the risk of
nonpayment of goods or
services by their buyers who
may be situated in the same
country as the supplier
(domestic risk) or a buyer
situated in another country
(export risk) against non-
payment as a result of
insolvency of the buyer or
nonpayment after an agreed
number of months after due-
date (protracted default) or
non-payment following an
event outside the control of
the buyer or the seller
(political risk cover). Political
risk cover is available only in
case of buyers outside India
and in those countries agreed
upon at the proposal stage.
Continue with the existing
definition.
L “Trade Credit transaction"
means a transaction between
two persons and or entities,
for supply of goods or services
on open and agreed terms.
“Trade Credit transaction"
means a transaction between
two legal entities, for supply of
goods or services on open and
agreed terms.
Trade Credit Insurance cannot
insure an individual hence the
person word has to be
removed.
M "Transaction on open terms"
means a transaction which is
not cash based transaction.
"Transaction on open terms"
means a transaction which is
not backed by advance
payment.
Modified to have better clarity
N "Trade receivable" means a
receivable in the hands of
seller arising out of a trade
credit transaction.
Continue with the existing
definition.
O "Trade Credit insurance
policy" is a conditional
insurance contract between
two parties (insurer and seller)
that cannot be traded and is
always directly related to an
Continue with the existing
definition.
74
underlying trade transaction,
which is either the delivery of
goods or of services. The
correct fulfillment of this
trade transaction and
satisfaction of the contract
terms is essential for credit
cover to exist
P "Whole turnover trade credit
insurance policy" means a
trade credit insurance policy
that covers all trade credit
receivables of all buyers,
pertaining to a seller.
Continue with the existing
definition.
ADDITIONAL DEFINITIONS
Proposed
ADDITIONAL DEFINITIONS
Proposed
Q Policy Holder "Policy-holder" may be a:
I) Seller / Supplier of goods or
services.
II) Factoring company as
defined by The Factoring
Regulation Act 2011 &
amendments thereof.
III) Bank / Financial Institution,
engaged in Trade Finance,
registered & regulated by
Regulatory Bodies
Policy Holder was not defined
in the earlier circular.
R TReDS or Invoice Discounting
e-Platforms
"TReDS" or Invoice Discounting
e-Platforms means any
Institutional platform
facilitating the financing or
discounting or similar
arrangements of trade
receivables through sole or
multiple financiers through
electronic platform.
75
S "Pre-Shipment Cover" "Pre-Shipment Cover" means
the commercial risk of
Insolvency of a buyer before
delivery or shipment of goods
or performance of service and
/or the political risk of
interruption of the
manufacturing of the goods or
performance of a service
T Micro & Small Enterprises Micro & Small Enterprises shall
be as defined by the MSMED
Act, 2006 and amendments
thereof.
U Government Buyer "Government Buyer" means
any entity that is authorized to
enter into commitments in the
name or on behalf of the
government of its country,
including the government itself
or government agencies whose
commitments are guaranteed
by the government.
V Project Cover “Project Cover” means
insurance of receivables against
non-payment by the principal
or buyer provided to a
contractor engaged in but not
limited to long term
infrastructure, civil and
industrial projects and services.
The project period should be
more than 6 months.
W Net Retention "Net Retention" means net
exposure of the Insurance
Company after considering the
existing reinsurance
arrangements
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II Applicability of 'Guidelines on
Product Filing Procedures for
General Insurance Products"
to trade credit insurance
1 No insurer shall issue a
financial guarantee.
Continue with the existing
provision.
2 All the existing credit
insurance policies shall remain
valid as per original contract
terms and conditions, till the
expiry of the current contract
period. The insurers are
directed to review the
creditworthiness of the buyers
and credit assessment and
management practices of the
policy holders under the
existing credit insurance
policies currently in force and
ensure that necessary
corrective action is taken.
Continue with the existing
provision.
3 All Trade Credit Insurance
policies will be subject to "file
& use procedures'' as
stipulated under the
"Guidelines on Product Filing
Procedures for General
Insurance Products" issued by
the Authority. No trade credit
insurance policy shall be sold
unless the product has prior
approval of the Authority.
Continue with the existing
provision.
4 The insurers intending to
underwrite trade credit
insurance business shall file
their products/revised
products, under "Product
Filing Procedures" and these
Continue with the existing
provision.
77
guidelines.
5 Scope of cover under trade
credit insurance policy - The
credit risk that is insured has
to have a direct link with an
underlying trade transaction,
i.e. the delivery of goods or
services. If no such direct link
exists, the outstanding
amount is not insurable under
a trade credit insurance
policy.
Continue with the existing
provision.
III Basic Requirements of a
Trade Credit Insurance Policy
An insurer shall offer trade
credit insurance policy only if
all the following minimum
requirements are met:
1 Policyholder's loss is non
receipt of trade receivable
arising out of a trade of goods
or services.
Policyholder's loss is non
receipt of trade receivable
arising out of an underlying
trade transaction.
This definition has been
modified to include policies
issued to Banks/FIs/Factors as
they are not sellers.
2 Policy-holder is a supplier of
goods or services, in
consideration for a fair market
value.
to be deleted Policy Holder is defined in I (Q)
3 No trade credit insurance
policy shall cover factoring,
reverse factoring, bill
discounting or any other
similar arrangement.
No Trade Credit insurance
policy shall cover reverse
factoring or any other similar
arrangement except for cross
border transaction
The revised guidelines propose
to allow policies to be issued to
Banks / FIs and Factors.
However, since reverse
factoring transactions are risky
and will involve anti selection
of buyers, we propose to allow
it only for cross border
transactions.
78
4 Policy-holder has a customer
(i.e. Buyer) who is liable to pay
a trade receivable to the
Policy-holder in return for the
goods and services received
by him from the seller, in
accordance with a policy
document filed with the
insurer.
There should be a Policy Holder
and Buyer as defined in Section
I (Q) and I (A) respectively.
5 Policy-holder undertakes to
pay premium for the entire
Policy Period.
Continue with the existing
provision.
6 Any other requirement that
may be specified by the
Authority from time to time.
Continue with the existing
provision.
IV Conditions on Trade Credit
Insurance
A Insurer
1 A trade credit insurance policy
shall not be issued to
banks/financiers/lenders.
A trade credit insurance policy
shall be issued to
banks/financiers/lenders for
Trade Related Transactions
except for covering loan default
of seller.
A credit insurance policy only
covers default by a buyer. It
does not cover default by the
seller/exporter.
2 Assignment of proceeds of a
claim under a trade credit
policy may be made to a bank
/ NBFC registered with RBI, in
the manner prescribed under
Section 38 of the Insurance
Act 1938.
May be deleted Assignment is already a part of
revised Insurance laws
(Amendment) Act 2015
3 A trade credit insurance policy
shall not offer cover to any
receivable arising from
transactions made other than
trade credit transaction.
Continue with the existing
provision.
79
4 The insurer while offering
cover for other services shall
undertake valuation of those
services considering its
methodology and past
valuations. These services
shall be offered at arms length
and valued in accordance with
relevant accounting
standards.
Continue with the existing
provision.
5 A trade credit insurance policy
can be sold to seller on whole
credit turnover basis only,
covering all buyers. However,
if the seller prefers to take
credit insurance cover for a
segment /product/or country,
the same shall be allowed
provided the cover is taken for
the whole credit turnover of
all buyers of that particular
segment / product or country.
A trade credit insurance policy
can be sold on
1). whole turnover basis to
cover all buyers of that
particular segment / product /
country.
2). Individual buyer covers can
be issued only for:
a). Micro & Small Enterprises.
(as defined in I (T))
b). Project covers (as defined in
I (V))
c). Bank / FIs / Factoring /
Similar Arrangements
3). Single Invoice Covers
through bill discounting /
Factoring / Similar
Arrangements shall be allowed
only on Invoice Discounting e-
Platforms.
6 The cover under trade credit
insurance policy is available
only to pre-agreed buyers and
upto the limits agreed. Any
change in the limits can be
effected only after prior
approval of the insurer.
Continue with the existing
provision.
80
7 A trade credit insurance policy
shall contain well-defined
credit limits for each of the
Buyers and shall also contain
an overall limit under the
policy.
Continue with the existing
provision.
8 An insurer shall necessarily
assess the credit risk of any
buyer who contributes more
than 2% of the total turnover
of the policy holder.
to be deleted It is proposed that every
Insurer shall have Board
Approved Risk Management
Guidelines which will be filed
with the Authority.
9 Every trade credit insurance
policy shall carry a
subrogation condition and no
waiver under any
circumstances shall be
allowed.
Continue with the existing
provision.
10 An insurer shall have the right
to reduce or cancel a credit
limit at any time, usually as a
result of adverse or negative
information. Where the policy
holder has a protection for the
same loss from a third party
other than through the
insurance policy, the insurer
shall have the right to review
such protection arrangement
and reduce/delete the cover
under the insurance policy.
This shall allow the insurer to
bring down the exposure in a
timely manner. The new credit
limit shall apply to all
deliveries that are made by
the policy holder to the buyer
after the date of insurer's
decision to reduce or cancel
the limits.
Continue with the existing
provision.
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11 Every insurer shall appoint a
credit management agency
with the approval of the Board
of Directors for the purposes
of assessing creditworthiness
of the policy holder and
buyers, assuring that the
buyers pay on time, keep
credit costs low, manage poor
debts in such a manner that
payment is received without
damaging the relationship
with that buyer, etc.
Every insurer shall appoint a
credit management agency or
have a Credit Management
services arrangement with a
Reinsurer or have an internal
system of assessment with the
approval of the Board of
Directors for the purposes of
assessing creditworthiness of
the policy holder and buyers,
assuring that the buyers pay on
time, keep credit costs low,
manage poor debts in such a
manner that payment is
received without damaging the
relationship with that buyer,
etc.
Many Reinsurance
arrangements provide for
technical support for risk
underwriting. Some Insurers
have developed their own
internal system of risk
underwriting and are not
dependent on external
agencies for risk assessment.
Hence the guidelines are
modified to reflects various
arrangements available to
Insurers.
12 The insurer before engaging a
credit management agency
shall ensure that there is no
conflict of interest position of
the credit management
agency with the policy holder.
The insurer availing the services
of a credit management
agency, shall ensure that there
is no conflict of interest of the
credit management agency
with the policy holder.
Modified in the context of the
revision proposed in the earlier
para.
13 A single specific trade credit
policy covering only one
shipment cannot be sold to a
prospect. The insurer can
issue credit insurance even if
the number of buyers is very
small. However, the insurer
needs to exercise due
diligence and caution if the
buyers sought to be covered
are very small in number.
to be deleted The specific shipment/invoice
cover has already been
addressed in para IV 5
14 No trade credit insurance
policy is allowed when
governmental, para
governmental agencies are
the buyers.
No trade credit insurance policy
shall cover Government Buyers
as defined under para I (U).
Clarified the definition of Govt
Buyer under Para I (U)
82
B Policyholder
1 A Policy-holder cannot take
out more than one trade
credit insurance Policy either
with the same insurer or any
other insurer in respect of the
same Buyer risk nor can the
insurer issue more than one
trade credit insurance policy
covering same risks emanating
for or from the same entity.
Continue with the existing
provision.
2 A trade credit policy shall not
grant an indemnity of more
than 85% of the trade
receivables from each buyer.
A trade credit policy shall not
grant an indemnity of more
than 90% of the trade
receivables from each buyer for
all policyholders and 95% in
case of political risks only for
Micro & Small Enterprises
(defined in para I (T)) when
they are the policy holder.
90% cover is in line with global
standards. 95% indemnity is
proposed for political risk only
for Micro & Small Enterprises
to provide relief in the event of
loss which is beyond their
control.
3 A Policy-holder shall be
obliged under the Policy to
notify adverse information
about the Buyer to the
insurer.
Continue with the existing
provision.
4 A Policy-holder shall not be
covered for Buyer's non-
payment of a trade receivable
on account of dispute with the
Policy-holder or supplier of
the goods or services until the
dispute gets resolved.
Continue with the existing
provision.
5 A policyholder shall file with
the insurer a statement of
credit policy credit
management and procedures
for monitoring of the
implementation of the credit
policy as part of the proposal
to seek insurance cover.
Continue with the existing
provision.
83
V Trade Credit Insurance
Underwriting
Trade Credit Insurance
Underwriting & Risk
Management
1 On the basis of information
provided in the proposal form,
Insurer's underwriter shall
prepare a policy proposal for
the prospect based on internal
Underwriting Guidelines. The
said guidelines shall be
approved by the Insurer's
Board of Directors specifying
authority levels for decision
on premium rates, discounting
premium rates, loss
deductibles, maximum
liability, premium pricing in
case of higher risk or loss
perception, no-claim bonus,
etc.
Every Insurer underwriting
Trade Credit Insurance Business
shall have Borad Approved
Underwriting and Risk
Management Policy, which
shall be filed with the
Authority.
Para V and VI have been
combined. Every Insurer has
Board approved guidelines to
write and manage risk. Also in
case of non incorporated
entities financial information is
not easily available. Cover is
also required mainly in this
segment. Every Insurer has
developed its own mechanism
to underwrite such buyers.
2 The insurer shall ensure that
the design and rating of
products is always on sound
and prudent underwriting
basis. The contingencies
insured under the product
should be clear and provide
transparent cover which is of
value to the insured.
to be deleted
3 The insurer shall utilize the
services of its appointed
actuary for valuation of
liabilities, investment
performance, solvency margin
ratio, design and pricing of
insurance products, creation
of reserves for outstanding
claims and any other matter
to be deleted
84
which the Board of Directors
deem fit.
4 The insurer shall take into
consideration the following
minimum parameters for
underwriting of the Policy:
a)Risk Pricing;
b)Trade Sector/Industry of the
Buyer;
c)Level of Insurable Turnover;
d)Debtors Turnover / Velocity
in comparison to the Credit
Terms / Terms of Payment
offered to the Buyer;
e)Quality of Buyer Base and
spread of Risk;
f)Bad Debts History of the
Prospect;
g)Internal Credit Management
of the Prospect
to be deleted
5 The insurer shall file with the
Authority the rating model for
the insurance cover to be
offered in the market
to be deleted
VI Risk Management for trade
credit insurance
1 The Insurer shall have internal
Risk Management Guidelines
to assess trade credit risk on
the Buyer, giving credit limits
on the Buyer and Buyer credit
limit review.
to be deleted
2 The insurer shall construct
suitable risk management
models, which articulate its
to be deleted
85
risk management strategies
covering the procedures,
prudential risk limits, review
and mitigation mechanisms
reporting and auditing
systems
3 The said Risk Management
guidelines shall be approved
by the Board of Directors of
the Insurer and shall clearly
specify authority levels for
acceptance, rejection, partial
rejection and review of credit
limits on the Buyer.
to be deleted
4 The insurer shall ensure that
the following minimum
parameters are taken into
account while framing Risk
management Guidelines:
to be deleted
a) Financial Parameters relating
to the Buyer
i) Buyer turnover for current
and three previous years,
to be deleted
ii) Yearly Profitability trends,
gross, operating and net
margins of the buyer for
current and three previous
years,
to be deleted
iii) Yearly operating cashflows
for current and three previous
years,
to be deleted
iv) Asset turnover ratio and
current ratio for current and
three previous years.
to be deleted
b) Non-Financial Information
about the Buyer.
to be deleted
i) Business activity of the to be deleted
86
Buyer
ii) Business and Political
environment and the Industry
in which the Buyer operates in
to be deleted
iii) Promoters of the Buyer,
their experience, background
and track record for the past
and current period
to be deleted
iv) Market information on
promoters of the Buyer in the
media
to be deleted
c) The insurer shall review and
revise all returns including the
system of periodical reviews
submitted to the Head Office,
to ensure effective
supervision and control and to
monitor their continued
viability. Synopsis of the
findings of the inspection I
audit I scrutiny and
compliance shall be put upto
the Audit Committee of the
Board at half-yearly intervals.
to be deleted
d) The insurer shall also provide
systems and checks to ensure
that delegated powers are
exercised prudently and
judiciously by the authorized
officials and has no adverse
fallout.
to be deleted
e) Where fewer than 10 buyers
are to be covered the insurer
shall use appropriate policy
conditions and underwriting
techniques, to place
extremely prudent compliance
obligations on the insured.
to be deleted
87
VII Claims Handling
1 The insurer shall have a
comprehensive "Claims
Manual" which gives the
manner in which the claims
shall be processed,
documentation, delegation of
authority, policy holders
servicing, grievance redressal
etc.
Continue with the existing
provision.
2 The insurer shall also have a
strong and efficient recovery
mechanism in place to follow-
up on defaults.
Continue with the existing
provision.
3 In respect of claims in excess
of retention limits, the direct
insurer shall Intimate the
reinsurer immediately on
receiving intimation of the
loss.
Continue with the existing
provision.
VII
I
Reinsurance Arrangements
1 The Insurers shall file with the
Board of Directors and the
Authority, details of
reinsurance arrangements
proposed to take care of the
exposures that arise on
account of the underwriting of
risks taken. This should cover
details of structure of
reinsurance programme
Continue with the existing
provision.
88
covering both proportional
and non- proportional
arrangements, net retentions,
obligatory cessions, if any,
security of reinsurers
placement of reinsurance
cessions, reinsurance
recoveries, outstanding loss
provisions, etc.
2 The Reinsurance agreement
with a Reinsurer shall be
appropriately drafted in order
to avoid a situation where in a
Reinsurer may deny its liability
to pay for a trade credit
insurance claim by using any
clause of the Reinsurance
Agreement instead of clauses
under the Trade Credit
Insurance Policy issued to a
Policy-holder.
The general insurance
conditions applying to trade
credit insurance will form an
integral part of the Reinsurance
agreement. The Reinsurer shall,
subject to the terms and
conditions of the agreement,
follow the underwriting
fortunes of the Reinsured in
respect of the risks which the
Reinsured has accepted in good
faith under insurance contracts
and the cover notes.
Have reworded to add better
clarity.
3 The aggregate net retentions
of the insurer for trade credit
insurance shall not exceed 5%
of his net-worth.
The aggregate net retentions of
the insurer for trade credit
insurance shall be as per the
applicable reinsurance
regulations & amendments
thereof.
IX Experience and Training
Requirements for employees
dealing with trade credit
insurance
Every insurer wanting to write
trade credit insurance shall
ensure that decisions of
acceptance of trade credit
insurance business are made
Continue with the existing
provision.
89
by persons with necessary
knowledge, training and
experience in the areas of
underwriting, risks
management, claims,
reinsurance, etc. Brief details
relating to these aspects shall
be filed along with the
Product Filing documents to
IRDAI.
X Reporting requirements to
IRDAI
1 The Insurer should report
following information with
IRDAI:
Continue with the existing
provision.
a) Policy-holder wise
earned and gross written
premium
b) Loss ratio for the trade
credit insurance product
c) Policy-holder wise -
Buyer wise claims reserves
d) Policy-holder wise -
Buyer wise claims paid
e) Policy-holder wise -
Buyer wise claims recovery
2 Periodic reporting Continue with the existing
provision.
a The Insurer should report the
above mentioned information
as follows:
90
i) Every six months-Within 30
days of every six months
ending on 30th
September and 31stMarch
ii) Every year-within 30days of
the end of 12month period on
31"March for each financial
year
iii) Every loss known to the
insurer, which is in excess of
1% of the networth of the
insurer, as and when
intimation is received by the
insurer.
b The Insurer should provide for
additional reports I
clarifications demanded by
IRDAI within 15 days of the
receipt of requisition from
IRDAI.
XII Further powers of the
Authority
1 The Authority shall have the
right to call, inspect or
investigate any document,
record or communication of
the insurer and/or Policy-
holder, if it is of the opinion
that the continued writing of
trade credit insurance
business is detriment to the
interest of the insurer.
Continue with the existing
provision.
2 The Authority shall declare
any trade credit insurance
policy granted in violation of
Continue with the existing
provision.
91
these guidelines and other
IRDAI Regulations as void. The
insurer shall notify this clause
in all policies.
3 The Authority may suspend
trade credit insurance
business of any insurer, if
found violating the
instructions of the Authority
from time to time, after giving
sufficient opportunity to the
insurer to be heard.
Continue with the existing
provision.
4 In order to remove any
difficulties in respect of the
application or interpretation
of any of the provisions of
these guidelines, the
Chairperson of the Authority
may issue appropriate
clarifications from time to
time.
Continue with the existing
provision.
92
Chapter 6
Additional Recommendations
1. To create Buyer Default Database with IIB with an access to all the
insurance companies providing credit insurance.
2. Access of CIBIL database or similar platforms by Insurance companies for
underwriting purposes. Also, a buyer default under Trade Credit Insurance
Policy should also be intimated to the Banks through CIBIL or similar
platforms
3. Use of Credit Insurance Products by Banks will meaningfully take off only if
RBI recognizes credit insurance as credit risk mitigation, equivalent to cash/
securities etc. Currently, RBI prescribes the following while considering
credit protection as eligible credit risk mitigation:
a. General principles wherein RBI recognized guarantees which are
direct, explicit, irrevocable and unconditional to be qualified as credit
risk mitigant and does not include insurance/ surety companies
(Source: RBI’s Master Circular on ‘Prudential Guidelines on Capital
Adequacy and Market Discipline - New Capital Adequacy Framework
(NCAF)’ dated July 1, 2015- in attached document: Annexure 1)
b. Further, it prescribes eligible guarantors which also has no specific
mention of Insurance/ surety companies other than ECGC
(Source: Master Circular – Basel III Capital Regulations – July 1, 2015-
in attached document in Annexure 2)
c. Once credit risk mitigation is there, banks can get capital relief while
shifting the risk exposure and accordingly calculate their capital
requirements. Given credit insurance is not considered as credit risk
93
mitigation, risk transfer to insurance companies, in case of a credit
insurance-backed transaction, is currently not allowed.
Insurance companies are not covered under credit risk mitigation as the
eligible guarantor thus banks were reluctant to use this as a credit risk
mitigation. Hence, it is imperative that in line with the global standards, as
also recognized under Basel III, credit insurance to be considered as eligible
credit risk mitigation tool under RBI guidelines. Highlighting the key points
from the circular released by RBI on NCAF & Basel III regulations in 2015.
4. Guarantee by banks is like Surety Business by Insurance companies across
the world which should also be explored for the benefits of our economy
through separate guidelines with discussions involving other Regulatory
Bodies as well.
94
SOURCES
IRDAI
ICISA
Berne Union
India Factoring
Trade Credit Insurance by Peter M Jones -
http://siteresources.worldbank.org/FINANCIALSECTOR/Resources/Primer15_TradeCredi
tInsurance_Final.pdf
RBI Website https://m.rbi.org.in/Scripts/FAQView.aspx?Id=88
IFC Factoring Figures 2018 - https://fci.nl/downloads/Annual%20Review%202019.pdf
(https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=924)
Report on the expert committee on Micro Small and Medium Enterprises dated June
2019 Chaired by Shri U.K.Sinha
Financing India’s MSMEs - (https://www.ifc.org/wps/wcm/connect/dcf9d09d-68ad-
4e54-b9b7-614c143735fb/Financing+India%E2%80%99s+MSMEs+-
+Estimation+of+Debt+Requirement+of+MSMEs+in+India.pdf?MOD=AJPERES&CVID=my
3Cmzl)
https://www.nasscom.in/about-us/what-we-do/industry-development/sme-landscape
https://www.cii.in/Sectors.aspx?enc=prvePUj2bdMtgTmvPwvisYH+5EnGjyGXO9hLECvTu
NuXK6QP3tp4gPGuPr/xpT2f
msme.gov.in/KPMG/CRISIL/CII
https://m.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=3504
(https://rbidocs.rbi.org.in/rdocs/notification/PDFs/85BL4697A788DAB5485B826CFA24D
35EA1BE.PDF)
(https://rbidocs.rbi.org.in/rdocs/notification/PDFs/58BS09C403D06BC14726AB6178318
0628D39.PDF)
95
ABBREVATIONS
AML = Anti-Money Laundering
BIS = Bank for International Settlements
CBIRC = China Banking & Insurance Regulatory Commission
CGTSI = Credit Guarantee Fund Trust for Small Industries
CIBIL = Credit Information Bureau (India) Limited
CRGFTLIH = Credit Risk Guarantee Fund Trust for Low Income Housing
ECAs = Export Credit Agencies
EDPMS = Export Data Processing and Monitoring System
E-way bill = Electronic Waybill
FCI = Factors Chain International
FEMA = Foreign Exchange Management Act
FIs = Financial Institutions
GDP = Gross Domestic Premium
GIC = General Insurance Corporation of India
IBC = Insolvency and Bankruptcy Code
ICISA = International Credit Insurance & Surety Association
IMF = International Monetary Fund
IRDAI = Insurance Regulatory & Development Authority of India
KYC = Know your Customer
LoB = Line of Business
LC = Letter of Credit
MIS = Management Information System
MLT = Medium / Long – Term
MSMEs = Micro, Small & Medium Enterprises
MSMED Act = Micro, Small & Medium enterprise development Act
NBFC = Non-Banking Financial Institution
NCAF = New Capital Adequacy Framework
NCGTC = National Credit Guarantee Trustee Company
NOF = Net Owned Fund
NPAs = Non Performing Assets
PSEs = Public sector enterprises
PRI = Political Risk Insurance
PRIS = Political Risk Insurance Scheme
PSU = Public Sector Undertaking
RBI = Reserve Bank of India
RXIL = Receivables Exchange of India Ltd
96
SBLC = Standby Letter of Credit
SCBs = Scheduled Commercial Banks
SIDBI = Small Industries Development Bank of India
SMEs = Small & Medium Enterprises
ST TC = Short Term Trade Credit
TCI = Trade Credit Insurance
TCIS = Trade Credit Insurance Scheme
TReDS = Trade Receivables Discounting Exchange
97
Annexure 1
98
99
Annexure 2
Extracts from RBI master circular on Prudential Guidelines on Capital Adequacy
and Market Discipline New Capital Adequacy Framework (NCAF) - July 1, 2015
(https://rbidocs.rbi.org.in/rdocs/notification/PDFs/85BL4697A788DAB5485B826CFA24D35EA1BE.PDF)
7. Credit Risk Mitigation
7.1 General Principles
7.1.1 Banks use several techniques to mitigate the credit risks to which they
are exposed. For example, exposures may be collateralized in whole or in
part by cash or securities, deposits from the same counterparty, guarantee
of a third party, etc. The revised approach to credit risk mitigation allows a
wider range of credit risk mitigants to be recognized for regulatory capital
purposes than is permitted under the 1988 Framework provided these
techniques meet the requirements for legal certainty as described in
paragraph 7.2 below. Credit risk mitigation approach as detailed in this
section is applicable to the banking book exposures. This will also be
applicable for calculation of the counterparty risk charges for OTC
derivatives and repo-style transactions booked in the trading book.
7.5 Credit risk mitigation techniques - guarantees
7.5.1 Where guarantees are direct, explicit, irrevocable and unconditional;
banks may take account of such credit protection in calculating capital
requirements.
7.5.2 A range of guarantors are recognized. As under the 1988 Accord, a
substitution approach will be applied. Thus, only guarantees issued by
entities with a lower risk weight than the counterparty will lead to
reduced capital charges since the protected portion of the counterparty
exposure is assigned the risk weight of the guarantor, whereas the
uncovered portion retains the risk weight of the underlying counterparty.
100
7.5.3 Detailed operational requirements for guarantees eligible for being
treated as a credit risk mitigant are as under:
7.5.4 Operational requirements for guarantees
(i) A guarantee (counter-guarantee) must represent a direct claim on the
protection provider and must be explicitly referenced to specific exposures
or a pool of exposures, so that the extent of the cover is clearly defined and
incontrovertible. The guarantee must be irrevocable; there must be no
clause in the contract that would allow the protection provider
unilaterally to cancel the cover or that would increase the effective cost of
cover as a result of deteriorating credit quality in the guaranteed exposure.
The guarantee must also be unconditional; there should be no clause in
the guarantee outside the direct control of the bank that could prevent the
protection provider from being obliged to pay out in a timely manner in the
event that the original counterparty fails to make the payment(s) due.
(ii) All exposures will be risk weighted after considering risk mitigation
available in the form of guarantees. When a guaranteed exposure is
classified as non-performing, the guarantee will cease to be a credit risk
mitigant and no adjustment would be permissible on account of credit risk
mitigation in the form of guarantees. The entire outstanding, net of specific
provision and net of realizable value of eligible collaterals / credit risk
mitigants, will attract the appropriate risk weight.
7.5.5 Additional operational requirements for guarantees
In addition to the legal certainty requirements in paragraphs 7.2 above, for
a guarantee to be recognized, the following conditions must be satisfied:
101
i) On the qualifying default/non-payment of the counterparty, the bank is
able in a timely manner to pursue the guarantor for any monies
outstanding under the documentation governing the transaction. The
guarantor may make one lump sum payment of all monies under such
documentation to the bank, or the guarantor may assume the future
payment obligations of the counterparty covered by the guarantee. The
bank must have the right to receive any such payments from the guarantor
without first having to take legal actions in order to pursue the
counterparty for payment.
ii) The guarantee is an explicitly documented obligation assumed by the
guarantor.
iii) Except as noted in the following sentence, the guarantee covers all types
of payments the underlying obligor is expected to make under the
documentation governing the transaction, for example notional amount,
margin payments etc. Where a guarantee covers payment of principal only,
interests and other uncovered payments should be treated as an unsecured
amount in accordance with paragraph
102
Annexure 3
Extracts from RBI Master Circular – Basel III Capital Regulations – July 1, 2015
(https://rbidocs.rbi.org.in/rdocs/notification/PDFs/58BS09C403D06BC14726AB61783180628D39.PDF)
7.5.6 Range of Eligible Guarantors (Counter-Guarantors)
Credit protection given by the following entities will be recognized:
(i) Sovereigns, sovereign entities (including BIS, IMF, European Central Bank and
European Community as well as those MDBs referred to in paragraph 5.5, ECGC
and CGTSI, CRGFTLIH), banks and primary dealers with a lower risk weight than
the counterparty;
(ii) Other entities that are externally rated except when credit protection is
provided to a securitization exposure. This would include credit protection
provided by parent, subsidiary and affiliate companies when they have a lower
risk weight than the obligor.
(iii) When credit protection is provided to a securitization exposure, other entities
that currently are externally rated BBB- or better and that were externally rated
A- or better at the time the credit protection was provided. This would include
credit protection provided by parent, subsidiary and affiliate companies when
they have a lower risk weight than the obligor.
As per Basel III guidelines credit protection given by following entities will be
recognized:
• Sovereign entities, PSEs, banks, and securities firms with a lower risk weight
than the counterparty
• Other entities that are externally rated except when credit protection is
provided to a securitisation exposure. This would include credit protection
103
provided by parent, subsidiary and affiliate companies when they have a
lower risk weight than the obligor
• when credit protection is provided to a securitization exposure, other
entities that currently are externally rated BBB- or better and that were
externally rated A- or better at the time the credit protection was provided.
This would include credit protection provided by parent, subsidiary and
affiliate companies when they have a lower risk weight than the obligor.
Sources:
“A global regulatory framework for more resilient banks and banking systems”
published by the Basel Committee in December 2010 (revised in June 2011).
In a QIS FAQ publication dated December 2002 (Chapter E: Credit Risk Mitigation),
the Basel Committee stated that insurance could be used to mitigate credit risk
provided it fulfills the operational requirement applicable to guarantees.